Jefferson Bancshares 10-K 2008 FY Annual report

U.S. SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended June 30, 2008

¨ 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: 0-50347

JEFFERSON BANCSHARES, INC.

(Exact name of registrant as specified in its charter)

Tennessee	45-0508261
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

120 Evans Avenue, Morristown, Tennessee	37814
(Address of principal executive offices)	(Zip Code)

Registrant’s telephone number, including area code: (423) 586-8421

Securities registered pursuant to Section 12(b) of the Act:

Title of each class	Name of each exchange on which registered
Common Stock, par value $0.01	The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large Accelerated Filer  ¨	Accelerated Filer  x
Non-accelerated Filer  ¨	Smaller Reporting Company  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 16b-2 of the Exchange Act).    Yes  ¨    No  x

The aggregate market value of the voting and non-voting common equity held by non-affiliates was $55.8 million, based upon the closing price ($10.10 per share) as quoted on the Nasdaq Global Market as of the last business day of the registrant’s most recently completed second fiscal quarter (December 30, 2007).

The number of shares outstanding of the registrant’s common stock as of August 29, 2008 was 6,194,932.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Proxy Statement for the 2008 Annual Meeting of Shareholders

are incorporated by reference in Part III of this Form 10-K.

INDEX

		Page
Part I
Item 1.	Business	1
Item 1A.	Risk Factors	13
Item 1B.	Unresolved Staff Comments	15
Item 2.	Properties	16
Item 3.	Legal Proceedings	16
Item 4.	Submission of Matters to a Vote of Security Holders	16
Part II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	17
Item 6.	Selected Financial Data	19
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operation	21
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	39
Item 8.	Financial Statements and Supplementary Data	40
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	40
Item 9A.	Controls and Procedures	40
Item 9B.	Other Information	41
Part III
Item 10.	Directors, Executive Officers and Corporate Governance	41
Item 11.	Executive Compensation	41
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	42
Item 13.	Certain Relationships and Related Transactions, and Director Independence	42
Item 14.	Principal Accountant Fees and Services	42
Part IV
Item 15.	Exhibits and Financial Statement Schedules	43
Signatures

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This report contains certain “forward-looking statements” within the meaning of the federal securities laws. These statements are not historical fact; rather, they are statements based on Jefferson Bancshares, Inc.’s current expectations regarding its business strategies, intended results and future performance. Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions.

Management’s ability to predict results or the effect of future plans or strategies is inherently uncertain. Factors which could affect actual results include: interest rate trends; the general economic climate in the market area in which Jefferson Bancshares operates, as well as nationwide; Jefferson Bancshares’ ability to control costs and expense; competitive products and pricing; loan delinquency rates; and changes in federal and state legislation and regulation. These factors should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such statements. Jefferson Bancshares assumes no obligation to update any forward-looking statements.

PART I

ITEM 1. BUSINESS

General

Jefferson Bancshares, Inc. (also referred to as the “Company” or “Jefferson Bancshares”) is the holding company for Jefferson Federal Bank (referred to as the “Bank” or “Jefferson Federal”).

Management of the Company and the Bank are substantially similar and the Company neither owns nor leases any property, but instead uses the premises, equipment and furniture of the Bank. Accordingly, the information set forth in this report, including the consolidated financial statements and related financial data, relates primarily to the Bank.

Jefferson Federal operates as a community-oriented financial institution offering traditional financial services to consumers and businesses in its market area. Jefferson Federal attracts deposits from the general public and uses those funds to originate loans, most of which it holds for investment.

Available Information

We maintain an Internet website athttp://www.jeffersonfederal.com. We make available our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities and Exchange Act of 1934, as amended, and other information related to us, free of charge, on this site as soon as reasonably practicable after we electronically file those documents with, or otherwise furnish them to, the Securities Exchange Commission. Our Internet website and the information contained therein or connected thereto are not intended to be incorporated into this annual report on Form 10-K.

Market Area

We are headquartered in Morristown, Tennessee, which is situated approximately 40 miles northeast of Knoxville, Tennessee in the northeastern section of the state. We consider Hamblen County, with an estimated 2007 population of approximately 62,000, and its contiguous counties to be our primary market area. The economy of our market area is primarily oriented to manufacturing and agriculture. Morristown and Hamblen County also serve as a hub for retail shopping and medical services for a number of surrounding rural counties. The manufacturing sector is focused on three types of products: automotive and heavy equipment components; plastics, paper and corrugated products; and furniture. According to the U.S. Bureau of Labor Statistics, the average monthly unemployment rate in Hamblen County has decreased from 5.7% for 2006 to 4.8% for 2007, which was slightly above both the state and national averages.

We began expansion into the Knoxville, Tennessee market in January 2005 with the opening of a lending office. We opened a full-service branch in Knoxville in mid-2006 and opened a second full-service branch office in

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July 2007. Knoxville’s population is approximately 182,000 and its economy is largely fueled by the location of the main campus of the University of Tennessee, the Oak Ridge National Laboratory, the National Transportation Research Center and the Tennessee Valley Authority. Additionally, Knoxville has many warehousing and distribution companies because of its central location in the eastern half of the United States. The average monthly unemployment rate for the Knoxville metropolitan statistical area has decreased from 4.1% for 2006 to 3.4% for 2007, which was below both the national and state averages.

Competition

We face significant competition for the attraction of deposits and origination of loans. Our most direct competition for deposits has historically come from the several financial institutions operating in our market area and, to a lesser extent, from other financial service companies, such as brokerage firms, credit unions and insurance companies. We also face competition for investors’ funds from money market funds and other corporate and government securities. At June 30, 2007, which is the most recent date for which data is available from the Federal Deposit Insurance Corporation, we held 23.7% of the deposits in Hamblen County, which is the second largest market share out of nine financial institutions with offices in the county at that date. However, banks owned by SunTrust Banks, Inc., First Tennessee National Corporation and Regions Financial Corporation, all of which are large regional bank holding companies, also operate in Hamblen County. These institutions are significantly larger than us and, therefore, have significantly greater resources.

Our competition for loans comes primarily from financial institutions in our market area, and to a lesser extent from other financial service providers, such as mortgage companies and mortgage brokers. Competition for loans also comes from the increasing number of non-depository financial service companies entering the mortgage market, such as insurance companies, securities companies and specialty finance companies.

We expect to continue to face significant competition in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Technological advances, for example, have lowered barriers to entry, allowed banks to expand their geographic reach by providing services over the Internet and made it possible for non-depository institutions to offer products and services that traditionally have been provided by banks. Federal law permits affiliation among banks, securities firms and insurance companies, which promotes a competitive environment in the financial services industry. Competition for deposits and the origination of loans could limit our growth in the future.

Lending Activities

General. Our loan portfolio consists of a variety of mortgage, commercial and consumer loans. As a community-oriented financial institution, we try to meet the borrowing needs of consumers and businesses in our market area. Mortgage loans constitute a significant majority of the portfolio, and commercial mortgage loans are the largest segment in that category.

One- to Four-Family Residential Loans. We originate mortgage loans to enable borrowers to purchase or refinance existing homes or to construct new one- to four-family homes. We offer fixed-rate mortgage loans with terms up to 30 years and adjustable-rate mortgage loans with terms up to 25 years. Borrower demand for adjustable-rate loans versus fixed-rate loans is a function of the level of interest rates, the expectations of changes in the level of interest rates, the difference between the interest rates and loan fees offered for fixed-rate mortgage loans and the first year interest rates and loan fees for adjustable-rate loans. The relative amount of fixed-rate mortgage loans and adjustable-rate mortgage loans that can be originated at any time is largely determined by the demand for each in a competitive environment and the effect each has on our interest rate risk.

The loan fees charged, interest rates and other provisions of mortgage loans are determined by us on the basis of our own pricing criteria and competitive market conditions. Interest rates and payments on our adjustable-rate loans generally are adjusted annually based on any change in the National Average Contract Mortgage Rate for the Purchase of Previously Occupied Homes by Combined Lenders as published by the Federal Housing Finance Board. Changes in this index tend to lag behind changes in market interest rates. Our adjustable-rate mortgage loans may have initial fixed-rate periods ranging from one to seven years.

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We originate all adjustable-rate loans at the fully indexed interest rate. The maximum amount by which the interest rate may be increased or decreased is generally 2% per year and the lifetime interest rate cap is generally 5% over the initial interest rate of the loan. Our adjustable-rate residential mortgage loans generally do not provide for a decrease in the rate paid below the initial contract rate. The inability of our residential real estate loans to adjust downward below the initial contract rate can contribute to increased income in periods of declining interest rates, and also assists us in our efforts to limit the risks to earnings and equity value resulting from changes in interest rates, subject to the risk that borrowers may refinance these loans during periods of declining interest rates.

While one- to four-family residential real estate loans are normally originated with up to 30-year terms, such loans typically remain outstanding for substantially shorter periods because borrowers often prepay their loans in full upon sale of the property pledged as security or upon refinancing the original loan. In addition, substantially all of the mortgage loans in our loan portfolio contain due-on-sale clauses providing that Jefferson Federal may declare the unpaid amount due and payable upon the sale of the property securing the loan. Jefferson Federal enforces these due-on-sale clauses to the extent permitted by law. Therefore, average loan maturity is a function of, among other factors, the level of purchase and sale activity in the real estate market, prevailing interest rates and the interest rates payable on outstanding loans.

Historically, we have not emphasized the origination of loans that conform to guidelines for sale in the secondary mortgage market. However, beginning in January 2005, we began originating loans for the secondary mortgage market. Loans are sold without recourse and on a servicing-released basis.We generally do not make conventional loans with loan-to-value ratios exceeding 85% and generally make loans with a loan-to-value ratio in excess of 85% only when secured by first liens on owner-occupied, one- to four-family residences. Loans with loan-to-value ratios in excess of 90% generally require private mortgage insurance or additional collateral. We require all properties securing mortgage loans in excess of $100,000 to be appraised by a board-approved appraiser. We require title insurance on all mortgage loans in excess of $25,000. Borrowers must obtain hazard or flood insurance (for loans on property located in a flood zone) prior to closing the loan.

Home Equity Lines of Credit. We offer home equity lines of credit on single family residential property in amounts up to 80% of the appraised value. Rates and terms vary by borrower qualifications, but are generally offered on a variable rate, open-end term basis with maturities of ten years or less.

Commercial Real Estate and Multi-Family Loans. An important segment of our loan portfolio is mortgage loans secured by commercial and multi-family real estate. Our commercial real estate loans are secured by professional office buildings, shopping centers, manufacturing facilities, hotels, vacant land, churches and, to a lesser extent, by other improved property such as restaurants and retail operations. We intend to continue to emphasize and grow this segment of our loan portfolio.

We originate both fixed- and adjustable-rate loans secured by commercial and multi-family real estate with terms up to 20 years. Fixed-rate loans have provisions that allow us to call the loan after five years. Adjustable-rate loans are generally based on prime and adjust monthly. Loan amounts generally do not exceed 85% of the lesser of the appraised value or the purchase price. When the borrower is a corporation, partnership or other entity, we generally require personal guarantees from significant equity holders. Currently, it is our philosophy to originate commercial real estate loans only to borrowers known to us and on properties in or near our market area.

At June 30, 2008, loans with principal balances of $500,000 or more secured by commercial real estate totaled $65.2 million, or 71.7% of commercial real estate loans, and loans with principal balances of $500,000 or more secured by multi-family properties totaled $1.5 million, or 36.7% of multifamily loans. At June 30, 2008, all of these loans were performing in accordance with their terms.

Construction Loans. We originate loans to finance the construction of one-to four-family homes and, to a lesser extent, multi-family and commercial real estate properties. At June 30, 2008, $5.6 million of our construction loans was for the construction of one- to four-family homes and $13.9 million was for the construction of commercial or multi-family real estate. We principally finance the construction of single-family, owner-occupied homes. Construction loans are generally made on a “pre-sold” basis; however, contractors who have sufficient financial strength and a proven track record are considered for loans for model and speculative purposes, with

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preference given to contractors with whom we have had successful relationships. We generally limit loans to contractors for speculative construction to a total of $350,000 per contractor. Construction loans generally provide for interest-only payments at fixed-rates of interest and have terms of six to 12 months. At the end of the construction period, the loan generally converts into a permanent loan. Construction loans to a borrower who will occupy the home, or to a builder who has pre-sold the home, will be considered for loan-to-value ratios of up to 85%. Construction loans for speculative purposes, models and commercial properties may be considered for loan-to-value ratios of up to 80%. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. We generally use in-house inspectors for construction disbursement purposes; however, we may rely on architect certifications and independent third party inspections for disbursements on larger commercial loans.

Land Loans. We originate loans secured by unimproved property, including lots for single family homes, raw land, commercial property and agricultural property. We originate both fixed- and adjustable-rate land loans with terms up to 15 years. Adjustable-rate loans are generally based on prime and adjust monthly. Loans secured by unimproved commercial property or for land development generally have five-year terms with a longer amortization schedule.

At June 30, 2008, our largest land loan had an outstanding balance of $4.9 million and was secured by commercial real estate. At June 30, 2008, loans with principal balances of $500,000 or more secured by unimproved property totaled $23.1 million, or 56.5% of land loans. All of these loans were performing in accordance with their terms at that date.

Commercial Business Loans. We extend commercial business loans on an unsecured and secured basis. Secured loans generally are collateralized by industrial/commercial machinery and equipment, livestock, farm machinery and, to a lesser extent, accounts receivable and inventory. We originate both fixed- and adjustable-rate commercial loans with terms up to 15 years. Fixed-rate loans have provisions that allow us to call the loan after five years. Adjustable-rate loans are generally based on prime and adjust monthly. Where the borrower is a corporation, partnership or other entity, we generally require personal guarantees from significant equity holders.

Consumer Loans. We offer a variety of consumer loans, including loans secured by automobiles and savings accounts. Other consumer loans include loans on recreational vehicles and boats, debt consolidation loans and personal unsecured debt.

The procedures for underwriting consumer loans include an assessment of the applicant’s payment history on other debts and ability to meet existing obligations and payments on the proposed loans. Although the applicant’s creditworthiness is a primary consideration, the underwriting process also includes a comparison of the value of the collateral, if any, to the proposed loan amount. We use a credit scoring system and charge borrowers with poorer credit scores higher interest rates to compensate for the additional risks associated with those loans.

Loan Underwriting Risks.

Adjustable-Rate Loans.While we anticipate that adjustable-rate loans will better offset the adverse effects of an increase in interest rates as compared to fixed-rate mortgages, the increased mortgage payments required of adjustable-rate loan borrowers in a rising interest rate environment could cause an increase in delinquencies and defaults. The marketability of the underlying property also may be adversely affected in a high interest rate environment. In addition, although adjustable-rate mortgage loans help make our asset base more responsive to changes in interest rates, the extent of this interest sensitivity is limited by the annual and lifetime interest rate adjustment limits.

Commercial and Multi-Family Real Estate Loans.Loans secured by commercial and multi-family real estate are generally larger and involve a greater degree of risk than one- to four-family residential mortgage loans. Of primary concern in commercial and multi-family real estate lending is the borrower’s creditworthiness and the feasibility and cash flow potential of the project. Payments on loans secured by income properties are often dependent on the successful operation or management of the properties. As a result, repayment of such loans may be subject to a greater extent than residential real estate loans to adverse conditions in the real estate market or the

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economy. In order to monitor cash flows on income properties, we require borrowers and loan guarantors, if any, to provide annual financial statements and rent rolls on multi-family loans. We also perform annual reviews and prepare write-ups on all lending relationships of $500,000 or more where the loan is secured by commercial or multi-family real estate.

Construction Loans.Construction financing is generally considered to involve a higher degree of risk of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property’s value at completion of construction or development and the estimated cost (including interest) of construction. During the construction phase, a number of factors could result in delays and cost overruns. If the estimate of construction costs proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the development. If the estimate of value proves to be inaccurate, we may be confronted, at or prior to the maturity of the loan, with a project having a value which is insufficient to assure full repayment. As a result of the foregoing, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, on the success of the ultimate project rather than the ability of the borrower or guarantor to repay principal and interest. If we are forced to foreclose on a project prior to or at completion due to a default, there can be no assurance that we will be able to recover all of the unpaid balance of, and accrued interest on, the loan as well as related foreclosure and holding costs.

Land Loans.Loans secured by undeveloped land or improved lots generally involve greater risks than residential mortgage lending because land loans are more difficult to evaluate. If the estimate of value proves to be inaccurate, in the event of default and foreclosure, we may be confronted with a property the value of which is insufficient to assure full repayment.

Commercial Loans.Commercial business lending generally involves greater risk than residential mortgage lending and involves risks that are different from those associated with commercial and multi-family real estate lending. Although the repayment of commercial and multi-family real estate loans depends primarily on the cash-flow of the property or related business, the underlying collateral generally provides a sufficient source of repayment. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral if a borrower defaults is often an insufficient source of repayment because accounts receivable may be uncollectible and inventories and equipment may be obsolete or of limited use, among other things. Accordingly, the repayment of a commercial business loan depends primarily on the cash-flow, character and creditworthiness of the borrower (and any guarantors), while liquidation of collateral is secondary.

Consumer Loans.Consumer loans may entail greater risk than do residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly, such as automobiles, boats and recreational vehicles. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.

Loan Originations. All of our portfolio loans are originated by in-house lending officers and are underwritten and processed in-house. We rely on advertising, referrals from realtors and customers, and personal contact by our staff to generate loan originations. We occasionally purchase participation interests in commercial real estate loans through other financial institutions in our market area.

Loan Approval Procedures and Authority. Loan approval authority has been granted by the Board of Directors to certain officers on an individual and combined basis for consumer (including residential mortgages) and commercial purpose loans up to a maximum of $1.0 million per transaction. All loans with aggregate exposure of $2.0 million or more require the approval of our Loan Committee or Board of Directors.

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The Loan Committee meets every two weeks to review all mortgage loans made within granted lending authority of $75,000 or more and all non-mortgage loans made within granted lending authority of $50,000 or more. The committee approves all requests which exceed granted lending authority or when the request carries aggregate exposure to us of $2.0 million or more. The minutes of the committee are reported to and reviewed by the Board of Directors.

Loans to One Borrower. The maximum amount that we may lend to one borrower and the borrower’s related entities is limited by regulation. At June 30, 2008, our regulatory limit on loans to one borrower was $9.9 million. At that date, our largest lending relationship was $9.8 million and consisted of multiple commercial real estate and commercial business loans. These loans were performing according to their original repayment terms at June 30, 2008.

Loan Commitments. We issue commitments for fixed-rate and adjustable-rate single-family residential mortgage loans conditioned upon the occurrence of certain events. Commitments to originate mortgage loans are legally binding agreements to lend to our customers and generally expire in 90 days or less.

Delinquencies. When a borrower fails to make a required loan payment, we take a number of steps to have the borrower cure the delinquency and restore the loan to current status. We make initial contact with the borrower when the loan becomes 17 days past due. If payment is not then received, additional letters and phone calls generally are made. When the loan becomes 60 days past due, we send a letter notifying the borrower that we will commence foreclosure proceedings if the loan is not brought current within 30 days. When the loan becomes 90 days past due, we will commence foreclosure proceedings against any real property that secures the loan or attempt to repossess any personal property that secures a consumer loan. If a foreclosure action is instituted and the loan is not brought current, paid in full or refinanced before the foreclosure sale, the real property securing the loan generally is sold at foreclosure. Exceptions on commencement of foreclosure actions for commercial real estate loans and mortgage loans are made on a case-by-case basis by the Board of Directors. We may consider loan workout arrangements with certain borrowers under certain circumstances.

Investment Activities

We have legal authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies and of state and municipal governments, deposits at the Federal Home Loan Bank of Cincinnati and certificates of deposit of federally insured institutions. Within certain regulatory limits, we also may invest a portion of our assets in corporate securities. We also are required to maintain an investment in Federal Home Loan Bank of Cincinnati stock.

At June 30, 2008, our investment portfolio consisted of municipal bonds with maturities of 20 years or less.

Our investment objectives are to provide and maintain liquidity, to maintain a balance of high quality investments, to diversify investments to minimize risk, to provide collateral for pledging requirements, to establish an acceptable level of interest rate risk, to provide an alternate source of low-risk investments when demand for loans is weak, and to generate a favorable return. Any two of the following officers are authorized to purchase or sell investments: the President, Executive Vice President and/or Vice President. There is a limit of $2.0 million par value on any single investment purchase unless approval is obtained from the Board of Directors. For mortgage-backed securities, real estate mortgage investment conduits and collateralized mortgage obligations issued by Ginnie Mae, Freddie Mac or Fannie Mae, purchases are limited to a current par value of $2.5 million without Board approval.

Deposit Activities and Other Sources of Funds

General. Deposits and loan repayments are the major sources of our funds for lending and other investment purposes. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are significantly influenced by general interest rates and money market conditions. We may use borrowings on a short-term basis to compensate for reductions in the availability of funds from other sources. Borrowings may also be used on a longer-term basis for general business purposes.

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Deposit Accounts. Substantially all of our depositors are residents of the State of Tennessee. Deposits are attracted from within our primary market area through the offering of a broad selection of deposit instruments, including NOW accounts, money market accounts, regular savings accounts, Christmas club savings accounts, certificates of deposit and retirement savings plans. We do not utilize brokered funds. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of our deposit accounts, we consider the rates offered by our competition, profitability to us, matching deposit and loan products and customer preferences and concerns. We generally review our deposit mix and pricing monthly. Our current strategy is to offer competitive rates, but not be the market leader in every type and maturity. In recent years, our advertising has emphasized transaction accounts, with the goal of shifting our mix of deposits towards a smaller percentage of higher cost time deposits.

Borrowings. We have relied upon advances from the Federal Home Loan Bank of Cincinnati to supplement our supply of lendable funds and to meet deposit withdrawal requirements. Advances from the Federal Home Loan Bank are typically secured by our first mortgage loans.

The Federal Home Loan Bank functions as a central reserve bank providing credit for member financial institutions. As a member, we are required to own capital stock in the Federal Home Loan Bank and are authorized to apply for advances on the security of such stock and certain of our mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States), provided certain standards related to creditworthiness have been met. Advances are made pursuant to several different 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 either on a fixed percentage of an institution’s net worth or on the Federal Home Loan Bank’s assessment of the institution’s creditworthiness. Under its current credit policies, the Federal Home Loan Bank generally limits advances to 50% of a member’s assets. The availability of Federal Home Loan Bank advances to each borrower is based on the financial condition and the degree of security provided to collateralize borrowings.

Personnel

As of June 30, 2008, we had 83 full-time employees and eight part-time employees, none of whom is represented by a collective bargaining unit. We believe our relationship with our employees is good.

Executive Officers

The executive officers of Jefferson Federal are elected annually by the Board of Directors and serve at the Board’s discretion. Ages presented are as of June 30, 2008. The executive officers of Jefferson Federal are:

Name	Age	Position
Anderson L. Smith	60	President and Chief Executive Officer
Douglas H. Rouse	55	Senior Vice President
Jane P. Hutton	49	Vice President and Chief Financial Officer
Eric S. McDaniel	37	Vice President and Senior Operations Officer
Janet J. Ketner	55	Executive Vice President of Retail Banking
Anthony J. Carasso	49	President–Knoxville Region

Biographical Information

Anderson L. Smithhas been President and Chief Executive Officer of Jefferson Bancshares since March 2003 and President and Chief Executive Officer of Jefferson Federal since January 2002. Prior to joining Jefferson Federal, Mr. Smith was President, Consumer Financial Services—East Tennessee Metro, First Tennessee Bank National Association. Age 60. Director since 2002.

Jane P. Hutton has been Treasurer and Secretary of Jefferson Bancshares since March 2003 and Vice President and Chief Financial Officer of Jefferson Federal since July 2002. Ms. Hutton was named Chief Financial Officer of Jefferson Bancshares in connection with the consummation of the Conversion on July 1, 2003. From June 1999 until July 2002, Ms. Hutton served as Assistant Financial Analyst. Age 49.

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Douglas H. Rouse has been Senior Vice President of Jefferson Federal since January 2002. From March 1994 until January 2002, Mr. Rouse served as Vice President. Age 55.

Eric S. McDaniel has been Vice President and Senior Operations Officer of Jefferson Federal since July 2002. From March 1996 until July 2002, Mr. McDaniel served as Director of Compliance and Internal Auditor. Age 37.

Janet J. Ketner has been Executive Vice President of Retail Banking since January 2006. Prior to joining Jefferson Federal, Ms. Ketner was Executive Vice President of First Tennessee Bank for Morristown, Dandridge and Greeneville, Tennessee. Age 55.

Anthony J. Carassohas been the President of Jefferson Federal’s Knoxville Region since January 2005. In 1999, Mr. Carasso was Chief Executive Officer and President of Union Planters in Murfreesboro, Tennessee. Since then, he has been President of two other Union Planters Banks, one in Somerset, Kentucky as well as Harriman, Tennessee. During his tenure in Harriman, he had a dual role as an Area Sales Manager managing 22 branches in 11 communities. Age 49.

Subsidiaries

We have one subsidiary, JFB Service Corporation, which has an ownership interest in Bankers Title of East Tennessee, LLC, a title insurance agency. Our subsidiary also has a small investment in a credit life reinsurance company and holds Silverton Bank stock.

Subsequent Event

On September 4, 2008, Jefferson Bancshares and State of Franklin Bancshares, Inc. (“State of Franklin Bancshares”), the parent company of State of Franklin Savings Bank, entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which State of Franklin Bancshares will merge with and into Jefferson Bancshares. Concurrent with the merger, it is expected that State of Franklin Savings Bank will merge with and into Jefferson Federal.

Under terms of the Merger Agreement, shareholders of State of Franklin Bancshares will be entitled to elect to receive either $10.00 in cash or 1.1287 shares of Jefferson Bancshares stock for each share of State of Franklin Bancshares stock they hold, subject to the election and allocation procedures detailed in the Merger Agreement. However, all shares of State of Franklin Bancshares common stock held by individuals residing outside of Tennessee will only be eligible to receive the cash consideration. Based on this structure and the current outstanding shares of State of Franklin Bancshares, the aggregate merger consideration will include approximately $4.3 million in cash and up to approximately 736,000 shares of Jefferson Bancshares stock.

The transaction is subject to customary closing conditions, including the receipt of regulatory approvals and approval by the shareholders of State of Franklin Bancshares. The merger is currently expected to be completed late in the third quarter of 2008 or early in the fourth quarter of 2008.

The Merger Agreement requires State of Franklin Bancshares to pay Jefferson Bancshares a fee equal to $543,000 if the Merger Agreement is terminated in certain circumstances that involve State of Franklin Bancshares’ receipt of a competing offer.

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REGULATION AND SUPERVISION

General

As a savings and loan holding company, Jefferson Bancshares is required by federal law to report to, and otherwise comply with, the rules and regulations of the Office of Thrift Supervision. Jefferson Federal is subject to extensive regulation, examination and supervision by the Office of Thrift Supervision, as its primary federal regulator, and the Federal Deposit Insurance Corporation, as the deposit insurer. Jefferson Federal is a member of the Federal Home Loan Bank System and, with respect to deposit insurance, of the Deposit Insurance Fund managed by the Federal Deposit Insurance Corporation. Jefferson Federal must file reports with the Office of Thrift Supervision and the Federal Deposit Insurance Corporation concerning its activities and financial condition in addition to obtaining regulatory approvals prior to entering into certain transactions such as mergers with, or acquisitions of, other savings institutions. The Office of Thrift Supervision conducts periodic examinations to test Jefferson Federal’s safety and soundness and compliance with various regulatory requirements. This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such regulatory requirements and policies, whether by the Office of Thrift Supervision, the Federal Deposit Insurance Corporation or Congress, could have a material adverse impact on us and our operations. Certain regulatory requirements applicable to us are referenced below or elsewhere herein. The description of statutory provisions and regulations applicable to savings institutions and their holding companies set forth in this report does not purport to be a complete description of such statutes and regulations and their effects on us and is qualified in its entirety by reference to the actual laws and regulations.

Holding Company Regulation

Jefferson Bancshares is a nondiversified unitary savings and loan holding company within the meaning of federal law. Under prior law, a unitary savings and loan holding company, such as Jefferson Bancshares, was not generally restricted as to the types of business activities in which it may engage, provided that the association continued to be a qualified thrift lender. See“Federal Savings Institution Regulation—QTL Test.” The Gramm-Leach-Bliley Act of 1999 provides that no company may acquire control of a savings institution after May 4, 1999 unless it engages only in the financial activities permitted for financial holding companies under the law or for multiple savings and loan holding companies as described below. Further, the Gramm-Leach-Bliley Act specifies that existing savings and loan holding companies may only engage in such activities. The Gramm-Leach-Bliley Act, however, grandfathered the unrestricted authority for activities with respect to unitary savings and loan holding companies existing prior to May 4, 1999, so long as the holding company’s savings institution subsidiary continues to comply with the QTL test. Jefferson Bancshares does not qualify for the grandfathering. Upon any non-supervisory acquisition by Jefferson Bancshares of another savings association or savings bank that meets the qualified thrift lender test (as described below) and is deemed to be a savings institution by the Office of Thrift Supervision, Jefferson Bancshares would become a multiple savings and loan holding company (if the acquired association is held as a separate subsidiary) and would generally be limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the Office of Thrift Supervision, and certain activities authorized by Office of Thrift Supervision regulations. However, the Office of Thrift Supervision has issued an interpretation concluding that multiple savings and loan holding companies may also engage in activities permitted for financial holding companies.

A savings and loan holding company is prohibited from, directly or indirectly, acquiring more than 5% of the voting stock of another savings institution or savings and loan holding company, without prior written approval of the Office of Thrift Supervision and from acquiring or retaining control of a depository institution that is not insured by the Federal Deposit Insurance Corporation. In evaluating applications by holding companies to acquire savings institutions, the Office of Thrift Supervision considers the financial and managerial resources and future prospects of the company and institution involved, the effect of the acquisition on the risk to the deposit insurance funds, the convenience and needs of the community and competitive factors.

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The Office of Thrift Supervision may not approve any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions: (1) the approval of interstate supervisory acquisitions by savings and loan holding companies; and (2) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions. States vary in the extent to which they permit interstate savings and loan holding company acquisitions.

Although savings and loan holding companies are not currently subject to specific capital requirements or specific restrictions on the payment of dividends or other capital distributions, federal regulations do prescribe such restrictions on subsidiary savings institutions as described below. Jefferson Federal must notify the Office of Thrift Supervision 30 days before declaring any dividend to Jefferson Bancshares. In addition, the financial impact of a holding company on its subsidiary institution is a matter that is evaluated by the Office of Thrift Supervision and the agency has authority to order cessation of activities or divestiture of subsidiaries deemed to pose a threat to the safety and soundness of the institution.

Acquisition of the Company. Under the Federal Change in Bank Control Act (“CIBCA”), a notice must be submitted to the Office of Thrift Supervision if any person (including a company or savings association), or group acting in concert, seeks to acquire “control” of a savings and loan holding company or savings association. A change of control may occur, and prior notice is required, upon the acquisition of 10% or more of the Company’s outstanding voting stock, unless the Office of Thrift Supervision has found that the acquisition will not result in a change of control of the Company. Under the CIBCA, the Office of Thrift Supervision has 60 days from the filing of a complete notice to act, taking into consideration certain factors, including the financial and managerial resources of the acquirer and the anti-trust effects of the acquisition. Any company that acquires control would then be subject to regulation as a savings and loan holding company.

Federal Savings Institution Regulation

Business Activities. The activities of federal savings institutions are governed by federal law and regulations. These laws and regulations delineate the nature and extent of the activities in which federal associations may engage. In particular, certain lending authority for a federal association,e.g., commercial, non-residential real property loans and consumer loans, is limited to a specified percentage of the institution’s capital or assets.

Capital Requirements. The Office of Thrift Supervision capital regulations require savings institutions to meet three minimum capital standards: a 1.5% tangible capital to total assets ratio, a 4% leverage (core capital) ratio (3% for certain institutions receiving the highest rating on the CAMELS examination rating system) and an 8% total risk-based capital ratio. In addition, the prompt corrective action regulations discussed below also establish, in effect, a minimum 2% tangible capital standard, a 4% leverage (core capital) ratio (3% for institutions receiving the highest CAMELS rating), and, together with the risk-based capital standard itself, a 4% Tier 1 risk-based capital standard. The Office of Thrift Supervision regulations also require that, in meeting the tangible, leverage and risk-based capital standards, institutions must generally deduct investments in and loans to subsidiaries engaged in activities as principal that are not permissible for a national bank.

The risk-based capital standards for savings institutions requires the maintenance of Tier 1 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, recourse obligations, residual interests and direct credit substitutes, are multiplied by a risk-weight factor of 0% to 100%, assigned by the Office of Thrift Supervision capital regulation based on the risks believed inherent in the type of asset. Core (Tier 1) capital is defined as common stockholders’ equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus, and minority interests in equity accounts of consolidated subsidiaries less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative perpetual preferred stock, long-term perpetual preferred stock, mandatory convertible debt, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.

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The Office of Thrift Supervision also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution’s capital level is or may become inadequate in light of the particular circumstances. At June 30, 2008, Jefferson Federal met each of its capital requirements.

Prompt Corrective Regulatory Action. The Office of Thrift Supervision is required to take certain supervisory actions against undercapitalized institutions, the severity of which depends upon the institution’s degree of undercapitalization. Generally, a savings institution that has a ratio of total capital to risk weighted assets of less than 8%, a ratio of Tier 1 (core) capital to risk-weighted assets of less than 4% or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be “undercapitalized.” A savings institution that has a total risk-based capital ratio less than 6%, a Tier 1 capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be “significantly undercapitalized” and a savings institution that has a tangible capital to assets ratio equal to or less than 2% is deemed to be “critically undercapitalized.” Subject to a narrow exception, the Office of Thrift Supervision is required to appoint a receiver or conservator within specified time frames for an institution that is “critically undercapitalized.” The regulation also provides that a capital restoration plan must be filed with the Office of Thrift Supervision within 45 days of the date a savings institution receives notice that it is “undercapitalized,” “significantly undercapitalized” or “critically undercapitalized.” Compliance with the plan must be guaranteed by any parent holding company in the amount of up to the lesser of 5% of the savings association’s total assets when it was deemed to be undercapitalized or the amount necessary to achieve compliance with applicable capital requirements. In addition, numerous mandatory supervisory actions become immediately applicable to an undercapitalized institution, including, but not limited to, increased monitoring by regulators and restrictions on growth, capital distributions and expansion. The Office of Thrift Supervision could also take any one of a number of discretionary supervisory actions, including the issuance of a capital directive and the replacement of senior executive officers and directors. Significantly and critically undercapitalized institutions are subject to additional mandatory and discretionary measures.

Insurance of Deposit Accounts. Deposits of Jefferson Federal are insured by the Deposit Insurance Fund of the Federal Deposit Insurance Corporation. Insurance premiums are based on a number of factors, primarily the risk of loss that insured institutions pose to the Deposit Insurance Fund. The Federal Deposit Insurance Corporation has the ability to adjust the insurance fund’s reserve ratio between 1.15% and 1.5%, depending on projected losses, economic changes and assessment rates at the end of a calendar year. The FDIC has adopted regulations that set assessment rates that took effect at the beginning of 2007 and were continued in 2008. The new assessment rates for most banks vary between five cents and seven cents for every $100 of deposits. A change in insurance premiums could have an adverse effect on the operating expenses and results of operations of Jefferson Federal. We cannot predict what insurance assessment rates will be in the future.

Insurance of deposits may be terminated by the Federal Deposit Insurance Corporation upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the Federal Deposit Insurance Corporation. We do not know of any practice, condition or violation that might lead to termination of deposit insurance.

In addition to the assessment for deposit insurance, institutions are required to make payments on bonds issued in the late 1980s by the Financing Corporation (“FICO”), and agency of the federal government established to finance takeovers of insolvent thrifts, to recapitalize a predecessor deposit insurance fund.

Qualified Thrift Lender Test. Federal law requires savings associations to meet a qualified thrift lender test. Under the test, a savings association is required to either qualify as a “domestic building and loan association” under the Internal Revenue Code or maintain at least 65% of its “portfolio assets” (total assets less: (1) specified liquid assets up to 20% of total assets; (2) intangibles, including goodwill; and (3) the value of property used to conduct business) in certain “qualified thrift investments” (primarily residential mortgages and related investments, including certain mortgage-backed securities) in at least 9 months out of each 12-month period. The extent to which education loans, credit card loans and small business loans may be considered “qualified thrift investments,” was expanded by legislation enacted several years ago.

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A savings association that fails the qualified thrift lender test is subject to certain operating restrictions and may be required to convert to a bank charter. As of June 30, 2008, Jefferson Federal met the qualified thrift lender test.

Limitation on Capital Distributions. Office of Thrift Supervision regulations impose limitations upon all capital distributions by a savings institution, including cash dividends, payments to repurchase its shares and payments to shareholders of another institution in a cash-out merger. Under the regulations, an application to and the prior approval of the Office of Thrift Supervision is required prior to any capital distribution if the institution does not meet the criteria for “expedited treatment” of applications under Office of Thrift Supervision regulations (i.e., generally, examination and Community Reinvestment Act ratings in the two top categories), the total capital distributions for the calendar year exceed net income for that year plus the amount of retained net income for the preceding two years, the institution would be undercapitalized following the distribution or the distribution would otherwise be contrary to a statute, regulation or agreement with or condition imposed by the Office of Thrift Supervision. If an application is not required, the institution must still provide prior notice to the Office of Thrift Supervision of the capital distribution if, like Jefferson Federal, it is a subsidiary of a holding company. In the event Jefferson Federal’s capital fell below its regulatory requirements or the Office of Thrift Supervision notified it that it was in need of more than normal supervision, Jefferson Federal’s ability to make capital distributions could be restricted. In addition, the Office of Thrift Supervision could prohibit a proposed capital distribution by any institution, which would otherwise be permitted by the regulation, if the Office of Thrift Supervision determined that such distribution would constitute an unsafe or unsound practice.

Transactions with Related Parties. Jefferson Federal’s authority to engage in transactions with “affiliates” (e.g., any company that controls or is under common control with an institution, including Jefferson Bancshares and any non-savings institution subsidiaries) is limited by federal law. The aggregate amount of covered transactions with any individual affiliate is limited to 10% of the capital and surplus of the savings institution. The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings institution’s capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type described in federal law. The purchase of low quality assets from affiliates is generally prohibited. Transactions with affiliates must generally be on terms and under circumstances that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. In addition, savings associations are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may purchase the securities of any affiliate other than a subsidiary.

The Sarbanes-Oxley Act of 2002 generally prohibits loans by Jefferson Bancshares to its executive officers and directors. However, that act contains a specific exception for loans by federally insured depository institutions to its executive officers and directors in compliance with federal banking laws. Under such laws, Jefferson Federal’s authority to extend credit to executive officers, directors and 10% shareholders (“insiders”), as well as entities such persons control, is limited. The law limits both the individual and aggregate amount of loans Jefferson Federal may make to insiders based, in part, on Jefferson Federal’s capital position and requires certain board approval procedures to be followed. Such loans are required to be made on terms substantially the same as those offered to unaffiliated individuals and not to involve more than the normal risk of repayment. There is an exception for loans made pursuant to a benefit or compensation program that is widely available to all employees of the institution and does not give preference to insiders over other employees. Extensions of credit to executive officers are subject to further restrictions and limits.

Standards for Safety and Soundness. The federal banking agencies have adopted Interagency Guidelines prescribing Standards for Safety and Soundness. The guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the Office of Thrift Supervision determines that a savings institution fails to meet any standard prescribed by the guidelines, the Office of Thrift Supervision may require the institution to submit an acceptable plan to achieve compliance with the standard.

Enforcement. The Office of Thrift Supervision has primary enforcement responsibility over savings associations and has the authority to bring actions against the institution and all institution-affiliated parties, including shareholders, and any attorneys, appraisers and accountants who knowingly or recklessly participate in

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wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors to institution of receivership, conservatorship or termination of deposit insurance. Civil penalties cover a wide range of violations and can amount to $25,000 per day, or even $1 million per day in especially egregious cases. The OTS also has enforcement authority over savings and loan holding companies such as Jefferson Bancshares. The Federal Deposit Insurance Corporation has the authority to recommend to the Director of the Office of Thrift Supervision that enforcement action be taken with respect to a particular savings institution. If action is not taken by the Director, the Federal Deposit Insurance Corporation has authority to take such action under certain circumstances. Federal law also establishes criminal penalties for certain violations.

Federal Home Loan Bank System

Jefferson Federal is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank provides a central credit facility primarily for member institutions. Jefferson Federal, as a member of the Federal Home Loan Bank of Cincinnati, is required to acquire and hold shares of capital stock in that Federal Home Loan Bank. Jefferson Federal was in compliance with this requirement with an investment in Federal Home Loan Bank stock at June 30, 2008 of $1.9 million.

The Federal Home Loan Banks are required to provide funds for the resolution of insolvent thrifts in the late 1980s and to contribute funds for affordable housing programs. These requirements could reduce the amount of dividends that the Federal Home Loan Banks pay to their members and could also result in the Federal Home Loan Banks imposing a higher rate of interest on advances to their members. If dividends were reduced, or interest on future Federal Home Loan Bank advances increased, Jefferson Federal’s net interest income would likely also be reduced.

Federal Reserve System

The Federal Reserve Board regulations require savings institutions to maintain non-interest earning reserves against their transaction accounts (primarily NOW and regular checking accounts). The regulations generally provide that reserves be maintained against aggregate transaction accounts as follows: a 3% reserve ratio is assessed on net transaction accounts up to and including $43.9 million; a 10% reserve ratio is applied above $43.9 million. The first $9.3 million of otherwise reservable balances (subject to adjustments by the Federal Reserve Board) are exempted from the reserve requirements. The amounts are adjusted annually. Jefferson Federal complies with the foregoing requirements.

ITEM 1A. RISK FACTORS

We may not be able to implement successfully our plans for growth.

We have operated out of our main office and two drive-through facilities in Morristown, Tennessee since 1963 and have historically considered Hamblen County to be our primary market area. Recently, our management began to implement a growth strategy that expands our presence in Morristown, as well as into Knoxville, Tennessee, approximately 40 miles southwest of Morristown. In mid-2006, we opened two full-service branch offices, one in Morristown and one in Knoxville. In addition, we opened a second full-service branch office in Knoxville in July 2007.

Our expansion strategy may not be accretive to earnings within a reasonable period of time. Numerous factors will affect our expansion strategy, such as our ability to select suitable office locations, real estate acquisition costs, competition, interest rates, managerial resources, our ability to hire and retain qualified personnel, the effectiveness of our marketing strategy and our ability to attract deposits. We can provide no assurance that we will be successful in increasing the volume of our loans and deposits by expanding our lending and branch network. Building and staffing new offices will increase our operating expenses. We can provide no assurance that we will be able to manage the costs and implementation risks associated with this strategy so that expansion of our lending and branch network will be profitable.

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A downturn in the local economy or a decline in real estate values could hurt our earnings.

The success of our business depends on our ability to generate profits and grow our franchise. We are located in Morristown, Tennessee and consider Hamblen County, with a population of 60,000, and its contiguous counties to be our primary market area, although we are currently expanding into the Knoxville region. The economy of the Hamblen County market area is based primarily on manufacturing and agriculture. Our primary lending activity is the origination of loans secured by real estate. Nearly all of these loans are made to borrowers who live and work in our primary market area. As a result, a downturn in the local economy could cause significant increases in nonperforming loans, which would hurt our earnings. Decreases in real estate values could adversely affect the value of property used as collateral for our loans which would expose us to a greater risk of loss. In addition, adverse employment conditions may have a negative effect on the ability of our borrowers to make timely repayments of their loans and on our ability to make new loans, which would have an adverse impact on our earnings.

Changes in interest rates could reduce our net interest income and earnings.

Our net interest income is the interest we earn on loans and investments less the interest we pay on our deposits and borrowings. Our net interest margin is the difference between the yield we earn on our assets and the interest rate we pay for deposits and our other sources of funding. Changes in interest rates—up or down—could adversely affect our net interest margin and, as a result, our net interest income. Although the yield we earn on our assets and our funding costs tend to move in the same direction in response to changes in interest rates, one can rise or fall faster than the other, causing our net interest margin to expand or contract. Our liabilities tend to be shorter in duration than our assets, so they may adjust faster in response to changes in interest rates. As a result, when interest rates rise, our funding costs may rise faster than the yield we earn on our assets, causing our net interest margin to contract until the yield catches up. Changes in the slope of the “yield curve”—or the spread between short-term and long-term interest rates—could also reduce our net interest margin. Normally, the yield curve is upward sloping, meaning short-term rates are lower than long-term rates. Because our liabilities tend to be shorter in duration than our assets, when the yield curve flattens or even inverts, we could experience pressure on our net interest margin as our cost of funds increases relative to the yield we can earn on our assets.

Strong competition within our market area could hurt our profits and slow growth.

We face intense competition both in making loans and attracting deposits. This competition has made it more difficult for us to make new loans and at times has forced us to offer higher deposit rates. Price competition for loans and deposits might result in us earning less on our loans and paying more on our deposits, which reduces net interest income. As of June 30, 2007, we held 23.7% of the deposits in Hamblen County, which is the second largest market share out of nine financial institutions with offices in the county at that date. However, banks owned by SunTrust Banks, Inc., First Tennessee National Corporation and Regions Financial Corporation, all of which are large regional bank holding companies, also operate in Hamblen County. These institutions are significantly larger than us and, therefore, have significantly greater resources. We expect competition to increase in the future as a result of legislative, regulatory and technological changes and the continuing trend of consolidation in the financial services industry. Our profitability depends upon our continued ability to compete successfully in our market area.

Our commercial real estate, commercial business and multi-family real estate loans expose us to increased lending risks.

At June 30, 2008, $147.2 million, or 51.7%, of our loan portfolio consisted of commercial real estate, commercial business and multi-family real estate loans. Commercial real estate and multi-family real estate loans generally expose a lender to greater risk of non-payment and loss than one- to four-family residential mortgage loans because repayment of the loans often depends on the successful operation of the property and the income stream of the borrowers. Commercial business loans expose us to additional risks because they typically are made on the basis of the borrower’s ability to make repayments from the cash flow of the borrower’s business and are secured by collateral that may depreciate over time. All three of these types of loans typically involve larger loan balances to single borrowers or groups of related borrowers compared to one- to four-family residential mortgage loans. Because such loans generally entail greater risk than one- to four-family residential mortgage loans, we may need to

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increase our allowance for loan losses in the future to account for the likely increase in probable incurred credit losses associated with the growth of such loans. Also, many of our commercial borrowers have more than one loan outstanding with us. Consequently, an adverse development with respect to one loan or one credit relationship can expose us to a significantly greater risk of loss compared to an adverse development with respect to a one- to four-family residential mortgage loan.

We may require further additions to our allowance for loan losses, which would reduce net income.

If our borrowers do not repay their loans or if the collateral securing their loans is insufficient to provide for the full repayment, we may suffer credit losses. Credit losses are inherent in the lending business and could have a material adverse effect on our operating results. We make various assumptions and judgments about the collectibility of our loan portfolio and provide an allowance for loan losses based on a number of factors. If our assumptions and judgments are wrong, our allowance for loan losses may not be sufficient to cover our losses. If we determine that our allowance for loan losses is insufficient, we would be required to take additional provisions for loan losses, which would reduce net income during the period those provisions are taken. In addition, the Office of Thrift Supervision periodically reviews our allowance for loan losses and may require us to increase our allowance for loan losses or to charge off particular loans.

Loss of our President and Chief Executive Officer could hurt our operations.

We rely heavily on our President and Chief Executive Officer, Anderson L. Smith. The loss of Mr. Smith could have an adverse effect on us because, as a small community bank, Mr. Smith is responsible for more aspects of our business than he might be at a larger financial institution with more employees. Moreover, as a small community bank, we have fewer management-level employees who are in a position to succeed and assume the responsibilities of Mr. Smith. We have entered into a three-year employment agreement with Mr. Smith. We do not have key-man life insurance on Mr. Smith.

We operate in a highly regulated environment and we may be adversely affected by changes in laws and regulations.

We are subject to extensive regulation, supervision and examination by the Office of Thrift Supervision, our chartering authority, and by the Federal Deposit Insurance Corporation, as insurer of our deposits. As a savings and loan holding company, Jefferson Bancshares is subject to regulation and supervision by the Office of Thrift Supervision. Such regulation and supervision govern the activities in which an institution and its holding company may engage, and are intended primarily for the protection of the insurance fund and depositors. Regulatory authorities have extensive discretion in their supervisory and enforcement activities, including the imposition of restrictions on our operations, the classification of our assets and determination of the level of our allowance for loan losses. Any change in such regulation and oversight, whether in the form of regulatory policy, regulations, legislation or supervisory action, may have a material impact on our operations.

ITEM 1B. UNRESOLVED STAFF COMMENTS

None.

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ITEM 2. PROPERTIES

We conduct our business through our main office and drive-through facilities. The following table sets forth certain information relating to these facilities as of June 30, 2008.

Location	Year Opened	Owned/ Leased
Main Office 120 Evans Avenue Morristown, Tennessee	1997	Owned
Drive-Through 143 E. Main Street Morristown, Tennessee	1995	Owned
Drive-Through 1960 W. Morris Blvd. Morristown, Tennessee	1998	Leased	(1)
Farragut Office 11916 Kingston Pike Farragut, Tennessee	2006	Owned
Merchants Green Office 123 Merchants Greene Blvd. Morristown, Tennessee	2006	Owned
Mortgage Office 525 West Morris Blvd. Morristown, Tennessee	2006	Leased	(2)
Knoxville Regional Headquarters 6501 Kingston Pike Knoxville, Tennessee	2007	Owned

(1) The current lease expires in April 2012.

(2) The current lease expires in April 2009.

As of June 30, 2008, the total net book value of the Company’s offices was $15.2 million.

ITEM 3. LEGAL PROCEEDINGS

Jefferson Bancshares is not a party to any pending legal proceedings. Periodically, there have been various claims and lawsuits involving Jefferson Federal, such as claims to enforce liens, condemnation proceedings on properties in which Jefferson Federal holds security interests, claims involving the making and servicing of real property loans and other issues incident to Jefferson Federal’s business. Jefferson Federal is not a party to any pending legal proceedings that it believes would have a material adverse effect on the financial condition or operations of the Company.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market for Common Equity and Related Stockholder Matters

Jefferson Bancshares’ common stock is listed on the Nasdaq Global Market under the symbol “JFBI.” As of June 30, 2008, Jefferson Bancshares had approximately 561 holders of record (excluding the number of persons or entities holding stock in street name through various brokerage firms), and 6,207,702 shares outstanding.

The following table sets forth high and low sales prices for each quarter during the fiscal years ended June 30, 2008 and June 30, 2007 for Jefferson Bancshares’ common stock, and corresponding quarterly dividends period per share.

	High		Low		Dividend Paid Per Share
Year Ended June 30, 2008
Fourth quarter	$	9.87	$	8.90	$	0.06
Third quarter		11.72		8.82		0.06
Second quarter		11.00		9.02		0.06
First quarter		11.90		10.00		0.06
Year Ended June 30, 2007
Fourth quarter	$	12.76	$	11.59	$	0.06
Third quarter		13.00		12.07		0.06
Second quarter		13.45		12.79		0.06
First quarter		13.57		12.58		0.06

The Board of Directors of Jefferson Bancshares has the authority to declare dividends on the common stock, subject to statutory and regulatory requirements. Declarations of dividends by the Board of Directors, if any, will depend upon a number of factors, including investment opportunities available to Jefferson Bancshares or Jefferson Federal, capital requirements, regulatory limitations, Jefferson Bancshares’ and Jefferson Federal’s financial condition and results of operations, tax considerations and general economic conditions. No assurances can be given, however, that any dividends will be paid or, if commenced, will continue to be paid.

Jefferson Bancshares is subject to the requirements of Tennessee law, which generally prohibits distributions to shareholders if, after giving effect to the distribution, the corporation would not be able to pay its debts as they become due in the usual course of business or the corporation’s total assets would be less than the sum of its total liabilities plus the amount that would be needed, if the corporation were to be dissolved at the time of the distribution, to satisfy the preferential rights upon dissolution of shareholders whose preferential rights are superior to those receiving the distribution.

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The following table provides certain information with regard to shares repurchased by the Company in the fourth quarter of fiscal 2008.

Period	(a) Total number of Shares (or Units) Purchased	(b) Average Price Paid per Share (or Unit)		(c) Total Number of Shares (or units) Purchased as Part of Publicly Announced Plans or Programs	(d) Maximum Number (or Appropriate Dollar Value) of Shares (or units) that May Yet Be Purchased Under the Plans or Programs
Month #1 April 1, 2008 through April 30, 2008	163	$	9.26	163	128,692	(1)
Month #2 May 1, 2008 through May 31, 2008	—		—	—	128,692	(1)
Month #3 June 1, 2008 through June 30, 2008	—		—	—	128,692	(1)
Total	163	$	12.13	163	128,692

(1) On February 24, 2006, the Company announced a stock repurchase program under which the Company may repurchase up to 690,261 shares of the Company’s common stock, from time to time, subject to market conditions. The repurchase program will continue until completed or terminated by the Board of Directors.

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ITEM 6. SELECTED FINANCIAL DATA

The selected financial information below is derived from the audited consolidated financial statements of the Company.

	At or For the Year Ended June 30,
	2008		2007		2006			2005		2004
Financial Condition Data:
Total assets	$	330,265	$	339,703	$	327,137		$	295,041	$	305,474
Loans receivable, net		282,483		274,881		254,127			208,438		186,601
Cash and cash equivalents, interest-bearing deposits and investment securities		21,094		35,012		43,801			64,393		101,416
Borrowings		33,000		44,800		52,400			17,000		6,000
Deposits		223,552		220,082		198,843			194,706		204,933
Stockholders’ equity		72,777		73,644		74,543			82,028		93,383
Operating Data:
Interest income	$	20,846	$	21,004	$	18,092		$	15,779	$	16,067
Interest expense		9,248		9,660		6,935			4,639		4,776
Net interest income		11,598		11,344		11,157			11,140		11,291
Provision for loan losses		451		30		(68	)		—		—
Net interest income after provision for loan losses		11,147		11,314		11,225			11,140		11,291
Noninterest income		1,520		1,355		1,375			1,204		1,067
Noninterest expense		9,889		10,070		8,950			7,031		10,265
Earnings before income taxes		2,778		2,599		3,650			5,313		2,093
Total income taxes		1,531		908		1,320			1,863		706
Net earnings	$	1,247	$	1,691	$	2,330		$	3,450	$	1,387
Per Share Data:
Earnings per share, basic	$	0.22	$	0.28	$	0.37		$	0.47	$	0.18
Earnings per share, diluted	$	0.22	$	0.28	$	0.37		$	0.47	$	0.18
Dividends per share	$	0.24	$	0.24	$	0.265		$	0.25	$	0.21

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	At or For the Year Ended June 30,
	2008		2007		2006		2005		2004
Performance Ratios:
Return on average assets	0.37	%	0.51	%	0.75	%	1.14	%	0.44	%
Return on average equity	1.69		2.28		2.99		3.92		1.46
Interest rate spread (1)	3.00		2.93		3.16		3.24		3.08
Net interest margin (2)	3.73		3.73		3.89		3.88		3.76
Noninterest expense to average assets	2.94		3.05		2.90		2.32		3.28
Efficiency ratio (3)	75.38		79.11		69.97		57.17		83.21
Average interest-earning assets to average interest-bearing liabilities	124.75		125.18		130.28		139.49		143.13
Dividend payout ratio (4)	109.09		85.71		71.62		53.19		116.67
Capital Ratios:
Tangible capital	19.57		19.33		20.09		22.72		22.21
Core capital	19.57		19.33		20.09		22.72		22.21
Risk-based capital	24.16		25.45		27.45		35.39		38.78
Average equity to average assets	21.87		22.48		25.21		29.00		30.40
Asset Quality Ratios:
Allowance for loan losses as a percent of total gross loans	0.65		0.71		0.85		1.09		1.31
Allowance for loan losses as a percent of nonperforming loans	609.97		778.88		629.57		538.26		228.90
Net charge-offs to average outstanding loans during the period	0.20		0.09		0.02		0.09		0.19
Nonperforming loans as a percent of total loans	0.11		0.09		0.13		0.20		0.58
Nonperforming assets as a percent of total assets	0.23		0.15		0.13		0.45		0.54

(1) Represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of interest-bearing liabilities.

(2) Represents net interest income as a percent of average interest-earning assets.

(3) Represents noninterest expense divided by the sum of net interest income and noninterest income, excluding gains or losses on the sale of securities. Excluding the $4.0 million contribution to the Jefferson Federal Charitable Foundation, the efficiency ratio for 2004 would be 50.78%.

(4) Reflects dividends per share declared in the period divided by earnings per share for the period.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

The objective of this section is to help shareholders and potential investors understand our views on our results of operations and financial condition. You should read this discussion in conjunction with the consolidated financial statements and notes to the consolidated financial statements that appear elsewhere in this report.

Overview.

Income

We have two primary sources of pre-tax income. The first is net interest income. Net interest income is the difference between interest income – which is the income that we earn on our loans and investments – and interest expense – which is the interest that we pay on our deposits and borrowings.

Our second principal source of pre-tax income is fee income – the compensation we receive from providing products and services. Most of our fee income comes from service charges on NOW accounts and fees for late loan payments. We also earn fee income from ATM charges, insurance commissions, safe deposit box rentals and other fees and charges.

We occasionally recognize gains or losses as a result of sales of investment securities or foreclosed real estate. These gains and losses are not a regular part of our income.

Expenses

The expenses we incur in operating our business consist of compensation and benefits expenses, occupancy expenses, equipment and data processing expense, deposit insurance premiums, advertising expenses, expenses for foreclosed real estate and other miscellaneous expenses.

Compensation and benefits consist primarily of the salaries and wages paid to our employees, fees paid to our directors and expenses for retirement and other employee benefits.

Occupancy expenses, which are the fixed and variable costs of building and equipment, consist primarily of lease payments, real estate taxes, depreciation charges, maintenance and costs of utilities.

Equipment and data processing expense includes fees paid to our third-party data processing service and expenses and depreciation charges related to office and banking equipment.

Deposit insurance premiums are payments we make to the Federal Deposit Insurance Corporation for insurance of our deposit accounts.

Expenses for foreclosed real estate include maintenance and repairs on foreclosed properties prior to sale.

Other expenses include expenses for attorneys, accountants and consultants, payroll taxes, franchise taxes, charitable contributions, insurance, office supplies, postage, telephone and other miscellaneous operating expenses.

Critical Accounting Policies

We consider accounting policies involving significant judgments 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. We consider the following to be our critical accounting policies: allowance for loan losses and deferred income taxes.

Allowance for Loan Losses. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Management reviews the level of the allowance on a monthly basis and establishes the

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provision for loan losses based on the composition of the loan portfolio, delinquency levels, loss experience, economic condition and other factors related to the collectibility of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future additions to the allowance may be necessary based on estimates that are susceptible to change as a result of changes in economic conditions and other factors. In addition, the Office of Thrift Supervision, as an integral part of its examination process, periodically reviews our allowance for loan losses. Such agency may require us to recognize adjustments to the allowance based on its judgments about information available to it at the time of its examination.

Deferred Income Taxes. We use the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. If current available information raises doubt as to the realization of the deferred tax assets, a valuation allowance is established. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We exercise significant judgment in evaluating the amount and timing of recognition of the resulting tax liabilities and assets, including projections of future taxable income. These judgments and estimates are reviewed on a continual basis as regulatory and business factors change.

Results of Operations for the Years Ended June 30, 2008, 2007 and 2006

Overview.

	2008			2007			2006			% Change 2008/2007		% Change 2007/2006
	(Dollars in thousands, except per share data)
Net earnings	$	1,247		$	1,691		$	2,330		(26.3	)%	(27.4	)%
Net earnings per share, basic	$	0.22		$	0.28		$	0.37		(21.4	)%	(24.3	)%
Net earnings per share, diluted	$	0.22		$	0.28		$	0.37		(21.4	)%	(24.3	)%
Return on average assets		0.37	%		0.51	%		0.75	%
Return on average equity		1.69	%		2.28	%		2.99	%

Net income was $1.2 million, or $0.22 per diluted share, for the year ended June 30, 2008 compared to net income of $1.7 million, or $0.28 per diluted share, for the year ended June 30, 2007. Net income for the year ended June 30, 2008 was negatively impacted by a $667,000 non-cash charge to deferred income tax expense to establish a valuation allowance against deferred tax assets. The deferred tax asset written down was the charitable contribution carryforward directly attributable to the contribution made to the Jefferson Federal Charitable Foundation in connection with the Company’s public offering in July 2003. Management determined that a valuation allowance was prudent because the tax benefit of the contribution may not be fully utilized based on an assessment of the Company’s future taxable income within the time allowed by the Internal Revenue Service. Excluding this tax charge, core net earnings were $1.9 million, or $0.33 per diluted share, for the year ended June 30, 2008 compared to GAAP earnings of $1.7 million, or $0.28 per diluted share, for the corresponding 2007 period. The increase in core net earnings for the year ended June 30, 2008 was due to increases in net interest income and noninterest income, as well as a decrease in noninterest expense more than offsetting an increase in the provision for loan losses.

While core net earnings is not a measure of performance calculated in accordance with U.S. generally accepted accounting principles (“GAAP”), the Company believes that this measure is important for the year ended June 30, 2008 to convey to investors the Company’s earnings for this period absent the $667,000 non-cash charge to establish a valuation allowance against deferred tax assets during fiscal 2008. As discussed above, the valuation allowance was related to the charitable contribution carryforward directly attributable to the Company’s contribution to the Jefferson Federal Charitable Foundation in July 2003. The Company calculated its core net earnings for the year ended June 30, 2008 by subtracting this $667,000 non-cash charge from net income for the period. Core net earnings should not be considered in isolation or as a substitute for net income, cash flows from operating activities or other income or cash flow statement data calculated in accordance with GAAP. Moreover, the manner in which the Company calculates core net earnings may differ from that of other companies reporting measures with similar names. A reconciliation of the Company’s GAAP and core net earnings for the year ended June 30, 2008 is set forth below.

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	Year Ended June 30,
	2008		2007
	(Dollars in thousands, except per share data)
GAAP net earnings	$	1,247	$	1,691
Plus: non-cash charge to deferred income tax expense	$	667		—
Core net earnings	$	1,914	$	1,691
GAAP earnings per diluted share	$	0.22	$	0.28
Plus: non-cash charge to deferred income tax expense	$	0.11		—
Core net earnings per diluted share	$	0.33	$	0.28

Net Interest Income.

The following table summarizes changes in interest income and expense for the years ended June 30, 2008, 2007 and 2006:

	Year Ended June 30,						% Change
	2008		2007		2006		2008/2007		2007/2006
Interest income:
Loans	$	19,782	$	19,605	$	16,152	0.9	%	21.4	%
Investment securities		605		983		1,248	(38.5	)	(21.2	)
Mortgage-backed securities		—		—		260	—		(100.0	)
Municipal securities		128		135		123	(5.2	)	9.8
Interest-earning deposits		221		172		216	28.5		(20.4	)
FHLB stock		110		109		93	0.9		17.2
Total interest income		20,846		21,004		18,092	(0.8	)	16.1
Interest expense:
Deposits		7,665		7,334		5,527	4.5		32.7
Borrowings		1,583		2,326		1,408	(31.9	)	65.2
Total interest expense		9,248		9,660		6,935	(4.3	)	39.3
Net interest income	$	11,598	$	11,344	$	11,157	2.2		1.7

Net interest income before loan loss provision increased $254,000 to $11.6 million for the year ended June 30, 2008 primarily due to lower interest expense resulting from a lower average balance of borrowings combined with lower funding costs. The interest rate spread and net interest margin for the year ended June 30, 2008 were 3.00% and 3.73%, respectively, compared to 2.93% and 3.73%, respectively, for the same period in 2007. The average yield on interest-earning assets decreased 19 basis points to 6.71% while the average volume of earning assets increased $6.3 million to $310.6 million for the year ended June 30, 2008 compared to the same period in 2007. The average rate paid on interest-bearing liabilities decreased 26 basis points to 3.71%, while the average volume of interest-bearing liabilities increased $5.9 million, to $249.0 million for the year ended June 30, 2008.

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Total interest income decreased $158,000, or 0.8%, to $20.8 million for the year ended June 30, 2008 compared to $21.0 million for the year ended June 30, 2007. The decrease in interest income was primarily due to a decline in the average balance of investments combined with a lower yield on the loan portfolio.

Interest on loans increased $177,000, or 0.9%, to $19.8 million for the year ended June 30, 2008. The increase in interest on loans was the result of a higher average balance, primarily due to growth in the commercial loan portfolio, offset by a decrease in the average yield. The average balance of loans increased $13.2 million, or 4.9%, to $282.1 million, while the average yield on loans decreased 28 basis points to 7.01%. The decrease in the average yield on loans is attributable to decreases in the prime lending rate.

Interest on investment securities decreased $385,000, or 34.4%, to $733,000 for the year ended June 30, 2008. The decrease was the result of a decline in the average balance of investment securities more than offsetting an increase in the average yield. The average balance of investment securities decreased $10.7 million, to $18.2 million for the year ended June 30, 2008 due to securities being called. The average yield on investments increased 16 basis points to 4.04% for 2008 compared to 3.88% for 2007. Dividends on Federal Home Loan Bank (“FHLB”) stock were $110,000 for the year ended June 30, 2008, compared to $109,000 for the year ended June 30, 2007.

Total interest expense decreased $412,000, or 4.3%, to $9.2 million for the year ended June 30, 2008, compared to $9.7 million for the year ended June 30, 2007. The decrease was primarily attributable to a decline in the rate paid on interest-bearing liabilities resulting from decreases in short term interest rates. Interest expense on deposits was $7.7 million for 2008 compared to $7.3 million for 2007. The average balance of deposits increased $15.0 million to $213.5 million as a result of growth in money market accounts and certificates of deposit. The average rate paid on deposits decreased 10 basis points to 3.59% for the year ended June 30, 2008. Interest expense on FHLB advances was $1.6 million for 2008 compared to $2.3 million for 2007. The average balance of FHLB advances decreased $9.2 million to $35.5 million and the average rate decreased 75 basis points to 4.46%, due to lower short term interest rates.

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Average Balances and Yields. The following table presents information regarding average balances of assets and liabilities, as well as the total dollar amounts of interest income and dividends from average interest-earning assets and interest expense on average interest-bearing liabilities and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing income or expense by the average balances of assets or liabilities, respectively, for the periods presented. For purposes of this table nonaccrual loans are included in average balances; however, accrued interest income has been excluded from these loans.

	Year Ended June 30,
	2008						2007						2006
	Average Balance		Interest and Dividends		Yield/ Cost		Average Balance		Interest and Dividends		Yield/ Cost		Average Balance		Interest and Dividends		Yield/ Cost
	(Dollars in thousands)
Interest-earning assets:
Loans	$	282,111	$	19,782	7.01	%	$	268,874	$	19,605	7.29	%	$	233,232	$	16,152	6.93	%
Mortgage-backed securities		—		—	—			—		—	—			5,465		260	4.76
Investment securities		14,056		605	4.30			24,470		983	4.02			34,226		1,248	3.65
Municipal securities		4,107		128	3.12			4,355		135	3.10			4,063		123	3.03
Daily interest deposits		8,501		221	2.60			4,845		172	3.55			7,882		216	2.74
Other earning assets		1,809		110	6.08			1,785		109	6.11			1,700		93	5.47
Total interest-earning assets		310,584		20,846	6.71			304,331		21,004	6.90			286,568		18,092	6.31
Noninterest-earning assets		25,996		—				26,222		—				22,480		—
Total assets	$	336,580		—			$	330,553		—			$	309,048		—
Interest-bearing liabilities:
Passbook accounts	$	8,929	$	49	0.55	%	$	10,138	$	51	0.50	%	$	12,122	$	61	0.50	%
NOW accounts		18,031		104	0.58			16,668		84	0.50			16,859		85	0.50
Money market accounts		46,132		1,399	3.03			37,821		1,394	3.69			37,900		1,228	3.24
Certificates of deposit		140,373		6,113	4.35			133,836		5,805	4.34			119,214		4,153	3.48
Total interest-bearing deposits		213,465		7,665	3.59			198,463		7,334	3.70			186,095		5,527	2.97
Borrowings		35,509		1,583	4.46			44,659		2,326	5.21			33,867		1,408	4.16
Total interest-bearing liabilities		248,974		9,248	3.71			243,122		9,660	3.97			219,962		6,935	3.15
Noninterest-bearing deposits		13,284		—				12,102		—				10,001		—
Other noninterest-bearing liabilities		709		—				1,008		—				1,170		—
Total liabilities		262,967		—				256,231		—				231,133		—
Stockholders’ equity		73,613		—				74,322		—				77,915		—
Total liabilities and stockholders’ equity	$	336,580					$	330,553					$	309,048
Net interest income			$	11,598					$	11,344					$	11,157
Interest rate spread					3.00	%					2.93	%					3.16	%
Net interest margin					3.73	%					3.73	%					3.89	%
Ratio of average interest-earning assets to average interest- bearing liabilities					124.75	%					125.18	%					130.28	%

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Rate/Volume Analysis. The following table sets forth the effects of changing rates and volumes on our net interest income. The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume). The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate). The net column represents the sum of the prior columns. For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.

	2008 Compared to 2007									2007 Compared to 2006
	Increase (Decrease) Due to									Increase (Decrease) Due to
	Volume			Rate			Net			Volume			Rate			Net
	(In Thousands)
Interest income:
Loans receivable	$	798		$	(621	)	$	177		$	2,565		$	888		$	3,453
Mortgage-backed securities		—			—			—			(260	)		—			(260	)
Investment securities		(454	)		76			(378	)		(412	)		147			(265	)
Municipals		(8	)		1			(7	)		9			3			12
Daily interest-bearing deposits and other interest-earning assets		77			(27	)		50			(555	)		527			(28	)
Total interest-earning assets		413			(571	)		(158	)		1,347			1,565			2,912
Interest expense:
Deposits		529			(198	)		331			387			1,420			1,807
Borrowings		(436	)		(307	)		(743	)		512			406			918
Total interest-bearing liabilities		93			(505	)		(412	)		899			1,826			2,725
Net change in interest income	$	320		$	(66	)	$	254		$	448		$	(261	)	$	187

Provision for Loan Losses.

The provision for loan losses for fiscal 2008 was $451,000 compared to a provision of $30,000 in fiscal 2007. Management reviews the level of the allowance for loan losses on a monthly basis and establishes the provision for loan losses based on changes in the nature and volume of the loan portfolio, the amount of impaired and classified loans, historical loan loss experience and other qualitative factors. The provision for loan losses for 2008 was increased primarily due to growth in commercial loans and current economic conditions. Net charge-offs for the year ended June 30, 2008 amounted to $570,000 compared to $247,000 for the year ended June 30, 2007. Nonperforming loans totaled $301,000 at June 30, 2008 compared to $251,000 at June 30, 2007.

An analysis of the changes in the allowance for loan losses is presented under “Allowance for Loan Losses and Asset Quality.”

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Noninterest Income. The following table shows the components of noninterest income and the percentage changes from 2008 to 2007 and from 2007 to 2006.

	2008		2007			2006			% Change 2008/2007		% Change 2007/2006
	(Dollars in Thousands)
Dividends from investments	$	36	$	69		$	44		(47.8	)%	56.8	%
Mortgage origination fees		338		451			578		(25.1	)	(22.0	)
Service charges and fees		768		522			544		47.1		(4.0	)
Gain (loss) on sale of investments		—		(29	)		(293	)	(100.0	)	(90.1	)
Gain on sale of equity investment		—		—			35		—		(100.0	)
Gain on sale of fixed assets		1		—			—		NM		—
Gain on sale of foreclosed property		51		39			170		30.8		(77.1	)
BOLI increase in cash value		224		211			206		6.2		2.4
Other		102		92			91		10.9		1.1
Total noninterest income	$	1,520	$	1,355		$	1,375		12.2		(1.5	)

For the year ended June 30, 2008, noninterest income increased $165,000, or 12.2%, to $1.5 million. Mortgage origination fee income decreased $113,000, or 25.1%, to $338,000 for 2008. For the year ended June 30, 2008, we originated $21.2 million in non-portfolio loans that were sold in the secondary market compared to $49.5 million for the year ended June 30, 2007. There was no loss on sale of investment securities for the year ended June 30, 2008 compared to a loss of $29,000 for 2007.

Noninterest Expense. The following table shows the components of noninterest expense and the percentage changes from 2008 to 2007 and from 2007 to 2006.

	2008		2007		2006		% Change 2008/2007		%Change 2007/2006
	(Dollars in Thousands)
Compensation and benefits	$	5,518	$	6,011	$	5,577	(8.2	)%	7.8	%
Occupancy		702		572		388	22.7		47.4
Equipment and data processing		1,458		1,377		1,059	5.9		30.0
Deposit insurance premiums		26		25		25	4.0		0.0
Advertising		246		324		370	(24.1	)	(12.4	)
Other		1,939		1,761		1,531	10.1		15.0
Total noninterest expense	$	9,889	$	10,070	$	8,950	(1.8	)	12.5

For the year ended June 30, 2008, noninterest expense decreased $181,000, or 1.8%, to $9.9 million due primarily to a decrease in compensation and benefits expense. Compensation expense decreased $493,000, or 8.2%, to $5.5 million for the year ended June 30, 2008 due to a lower number of employees. Occupancy expense increased $130,000, or 22.7%, to $702,000 and equipment and data processing expense increased $81,000, or 5.9%, to $1.5 million as a result of the operation of an additional branch office in Knoxville, Tennessee.

Income Taxes.

For the year ended June 30, 2008, income tax expense increased $623,000, or 68.6%, to $1.5 million due to the non-cash charge to deferred income tax expense to establish a valuation allowance against the charitable contribution carryforward. As previously mentioned, the carryforward is directly attributable to the contribution made to the Jefferson Federal Charitable Foundation in connection with the Company’s public offering in July 2003.

Balance Sheet Analysis

Loans. Net loans increased $7.6 million, or 2.8%, to $282.5 million at June 30, 2008. Our primary lending activity is the origination of loans secured by real estate. We originate real estate loans secured by one- to four-family homes, commercial real estate, multi-family real estate and land. We also originate construction loans and

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home equity loans. At June 30, 2008, real estate loans totaled $224.6 million, or 78.9% of our total loans, compared to $225.5 million, or 81.4% of total loans at June 30, 2007 and $209.4 million, or 81.6% of total loans, at June 30, 2006. Real estate loans decreased $882,000, or 0.4%, in the year ended June 30, 2008 and increased $16.1 million, or 7.7%, in the year ended June 30, 2007.

Commercial real estate loans increased $4.0 million, or 4.6%, to $90.9 million in the year ended June 30, 2008 and increased $9.4 million, or 12.1%, to $86.9 million in the year ended June 30, 2007. Commercial real estate loans increased due to our emphasis on this type of lending. At June 30, 2008, commercial real estate loans represented 40.5% of mortgage loans and 32.0% of total loans.

One-to four-family loans decreased $6.4 million, or 9.1%, to $63.3 million for the year ended June 30, 2008 and decreased $7.7 million, or 10.0%, to $69.7 million for the year ended June 30, 2007. At June 30, 2008, one-to four-family loans represented 28.2% of mortgage loans and 22.3% of total loans.

Multi-family real estate loans decreased $4.0 million, or 48.4% in the year ended June 30, 2008 and increased $253,000, or 3.2% in the year ended June 30, 2007. Construction loans decreased $2.1 million, or 9.6%, in the year ended June 30, 2008 and increased $8.2 million, or 60.8%, in the year ended June 30, 2007. Land loans increased $7.3 million, or 21.6%, in the year ended June 30, 2008 and increased $6.5 million, or 23.8%, in the year ended June 30, 2007.

Commercial business loans increased $10.4 million, or 24.9%, in the year ended June 30, 2008 and increased $6.0 million, or 16.8%, in the year ended June 30, 2007. Since January 2002, a significant portion of the commercial business loans that we have originated have been tied to prime and, thus, reprice quickly as interest rates change.

We originate a variety of consumer loans, including loans secured by automobiles, mobile homes and deposit accounts at Jefferson Federal. Consumer loans totaled $7.9 million and represented 2.8% of total loans at June 30, 2008, compared to $10.0 million, or 3.6% of total loans, at June 30, 2007 and $11.5 million, or 4.5% of total loans, at June 30, 2006. Consumer loans decreased in the year ended June 30, 2008 due to a decrease in indirect automobile loans.

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The following table sets forth the composition of our loan portfolio at the dates indicated.

	At June 30,
	2008					2007					2006					2005					2004
	Amount			Percent		Amount			Percent		Amount			Percent		Amount			Percent		Amount			Percent
	(Dollars in thousands)
Real estate loans:
Residential one- to four-family	$	63,340		22.3	%	$	69,693		25.1	%	$	77,415		30.2	%	$	79,652		37.7	%	$	84,784		44.8	%
Home equity lines of credit		5,723		2.0			5,470		2.0			5,954		2.3			4,898		2.3			3,143		1.7
Commercial		90,933		32.0			86,929		31.4			77,519		30.2			54,252		25.7			59,993		31.7
Multi-family		4,219		1.5			8,182		3.0			7,929		3.1			8,568		4.1			9,213		4.9
Construction		19,553		6.9			21,634		7.8			13,454		5.2			7,029		3.3			3,001		1.6
Land		40,862		14.4			33,604		12.1			27,133		10.6			14,415		6.8			10,760		5.7
Total real estate loans		224,630		78.9			225,512		81.4			209,404		81.6			168,814		80.0			170,894		90.2
Commercial business loans		52,037		18.3			41,667		15.0			35,665		13.9			34,603		16.4			12,640		6.7
Non-real estate loans:
Automobile loans		3,973		1.4			6,423		2.3			8,458		3.3			4,457		2.1			2,200		1.2
Mobile home loans		60		0.0			82		0.0			234		0.1			379		0.2			531		0.3
Loans secured by deposits		930		0.3			978		0.4			977		0.4			1,041		0.5			1,084		0.6
Other consumer loans		2,961		1.0			2,540		0.9			1,854		0.7			1,705		0.8			2,038		1.1
Total non-real estate loans		7,924		2.8			10,023		3.6			11,523		4.5			7,582		3.6			5,853		3.1
Total gross loans		284,591		100.00	%		277,202		100.0	%		256,592		100.0	%		210,999		100.0	%		189,387		100.0	%
Less:
Unearned discount on loans		—					—					—					—					(1	)
Deferred loan fees, net		(272	)				(366	)				(293	)				(268	)				(306	)
Allowance for losses		(1,836	)				(1,955	)				(2,172	)				(2,293	)				(2,479	)
Total loans receivable, net	$	282,483				$	274,881				$	254,127				$	208,438				$	186,601

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The following table sets forth certain information at June 30, 2008 regarding the dollar amount of principal repayments becoming due during the periods indicated for loans. The table does not include any estimate of prepayments which significantly shorten the average life of all loans and may cause our actual repayment experience to differ from that shown below. Demand loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.

	Real Estate Loans		Commercial Business Loans		Consumer Loans		Total Loans
	(In thousands)
Amounts due in:
One year or less	$	55,274	$	18,380	$	2,992	$	76,646
More than one to three years		43,973		17,637		2,833		64,443
More than three to five years		52,639		9,722		1,988		64,349
More than five to 15 years		37,642		5,591		111		43,344
More than 15 years		35,102		707		—		35,809
Total	$	224,630	$	52,037	$	7,924	$	284,591

The following table sets forth the dollar amount of all loans at June 30, 2008 that are due after June 30, 2009 and have either fixed interest rates or floating or adjustable interest rates.

	Fixed-Rates		Floating or Adjustable Rates		Total
	(In thousands)
Real estate loans:
One- to four-family	$	18,170	$	41,548	$	59,718
Home equity lines of credit		–		5,721		5,721
Commercial		36,396		34,710		71,106
Multi-family		2,035		1,086		3,121
Construction		387		5,208		5,595
Land		12,799		11,296		24,095
Commercial business loans		22,738		10,919		33,657
Consumer loans		4,625		307		4,932
Total	$	97,150	$	110,795	$	207,945

The following table shows activity in our loan portfolio, excluding loans held for sale, during the periods indicated.

	Year Ended June 30,
	2008			2007			2006
	(In thousands)
Total loans at beginning of period	$	277,202		$	256,592		$	210,999
Loans originated:
Real estate		75,879			87,254			87,114
Commercial business		79,396			65,290			59,398
Consumer		8,691			8,891			15,385
Total loans originated		163,966			161,435			161,897
Loan principal repayments		(156,577	)		(140,825	)		(116,304	)
Net loan activity		7,389			20,610			45,593
Total gross loans at end of period	$	284,591		$	277,202		$	256,592

Investments. Our investment portfolio consists of municipal bonds with maturities of 20 years or less. Investment securities decreased $23.8 million, or 87.2%, in the year ended June 30, 2008 due primarily to calls and maturities of investment securities. Proceeds from called investment securities were used to repay borrowings and to fund growth in the loan portfolio. We do not hold any Federal Home Loan Mortgage Corporation (“Freddie Mac”) or Federal National Mortgage Association (“Fannie Mae”) preferred or common stock in our investment portfolio.

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The following table sets forth the carrying values of our investment securities portfolio at the dates indicated. All of our investment securities are classified as available-for-sale.

	At June 30,
	2008				2007				2006
	Amortized Cost		Fair Value		Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(Dollars in thousands)
Federal agency securities	$	—	$	—	$	23,339	$	23,061	$	28,330	$	27,503
Municipal securities		3,506		3,478		4,339		4,217		4,502		4,342
Mortgage-backed securities		—		—		—		—		—		—
Total	$	3,506	$	3,478	$	27,678	$	27,278	$	32,832	$	31,845

The following table sets forth the maturities and weighted average yields of investment securities at June 30, 2008.

	More than One Year to Five Years				More than Five Years to Ten Years				More than Ten Years				Total
	Carrying Value		Weighted Average Yield		Carrying Value		Weighted Average Yield		Carrying Value		Weighted Average Yield		Carrying Value		Weighted Average Yield
Federal agency securities	$	—	—	%	$	—	—	%	$	—	—	%	$	—	—	%
Municipal securities		1,226	3.19	%		1,401	3.88	%		474	4.28	%	$	3,101	3.67	%
Total	$	1,226	3.19	%	$	1,401	3.88	%	$	474	4.28	%	$	3,101	3.67	%

Deposits. Our primary source of funds is our deposit accounts. The deposit base is comprised of checking, savings, money market and time deposits. These deposits are provided primarily by individuals and businesses within our market area. We do not use brokered deposits as a source of funding. Total deposits increased $3.5 million, or 1.6%, to $223.6 million at June 30, 2008 primarily as a result of an increase in transaction accounts. Time deposits decreased $13.5 million, or 9.7%, to $126.7 million, while money market accounts increased $8.5 million, or 20.5%, to $49.8 million at June 30, 2008. The increase in the balance of transaction accounts was attributable to our emphasis on increasing the number of both retail and business accounts through marketing efforts and competitive pricing on money market accounts.

	At June 30,
	2008		2007		2006
	(In thousands)
Noninterest-bearing accounts	$	17,517	$	12,561	$	10,806
NOW accounts		20,352		16,230		16,408
Passbook accounts		9,153		9,690		11,524
Money market deposit accounts		49,781		41,312		35,502
Certificates of deposit		126,749		140,289		124,603
Total	$	223,552	$	220,082	$	198,843

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The following table indicates the amount of jumbo certificates of deposit by time remaining until maturity as of June 30, 2008. Jumbo certificates of deposit require minimum deposits of $100,000.

	Certificates of Deposit
	(In thousands)
Maturity Period
Three months or less	$	17,773
Over three through six months		12,348
Over six through twelve months		3,130
Over twelve months		10,221
Total	$	43,472

The following table sets forth the time deposits classified by rates at the dates indicated.

	At June 30,
	2008		2007		2006
	(In thousands)
1.01 - 2.00%	$	2,234	$	—	$	60
2.01 - 3.00%		25,351		1,410		7,914
3.01 - 4.00%		60,067		12,888		35,795
4.01 - 5.00%		33,608		86,676		77,152
5.01 - 6.00%		5,489		39,315		3,682
Total	$	126,749	$	140,289	$	124,603

The following table sets forth the amount and maturities of time deposits at June 30, 2008.

	Amount Due
	Less Than One Year		1-2 Years		2-3 Years		3-4 Years		Total		Percent of Total Certificate Accounts
	(Dollars in thousands)
1.01 - 2.00%	$	2,234	$	—	$	—	$	—	$	2,234	1.8	%
2.01 - 3.00%		21,635		1,569		2,147		—		25,351	20.0
3.01 - 4.00%		43,740		1,092		14,921		314		60,067	47.4
4.01 - 5.00%		26,168		4,505		2,680		255		33,608	26.5
5.01 - 6.00%		5,489		—		—		—		5,489	4.3
Total	$	99,266	$	7,166	$	19,748	$	569	$	126,749	100.0	%

Borrowings. We have relied upon advances from the Federal Home Loan Bank (“FHLB”) of Cincinnati to supplement our supply of lendable funds and to meet deposit withdrawal requirements. FHLB advances were $33.0 million at June 30, 2008 compared to $44.8 million at June 30, 2007. The following table presents certain information regarding our use of FHLB advances during the periods and at the dates indicated.

	Year Ended June 30,
	2008			2007			2006
	(Dollars in thousands)
Maximum amount of advances outstanding at any month end	$	44,300		$	48,900		$	52,400
Average advances outstanding		35,509			44,659			33,867
Weighted average interest rate during the period		4.46	%		5.21	%		4.16	%
Balance outstanding at end of period	$	33,000		$	44,800		$	52,400
Weighted average interest rate at end of period		4.14	%		5.10	%		4.49	%

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Stockholders’ Equity.Stockholders’ equity decreased $867,000 to $72.8 million at June 30, 2008 due to the repurchase of company stock. During the year ended June 30, 2008, there were 203,884 shares of Company common stock purchased through the repurchase program at a cost of $2.2 million. At June 30, 2008, an additional 128,692 shares remained eligible for repurchase under the current stock repurchase program. Retained earnings decreased $117,000 to $35.0 million at June 30, 2008 due to net income of $1.2 million more than offset by dividends in the amount of $1.3 million. Unrealized gains and losses, net of taxes, in the available-for-sale investment portfolio are reflected as an adjustment to stockholders’ equity. At June 30, 2008, the adjustment to stockholders’ equity was a net unrealized loss of $17,000 compared to a net unrealized loss of $246,000 at June 30, 2007.

Allowance for Loan Losses and Asset Quality

Allowance for Loan Losses.The allowance for loan losses is a valuation allowance for probable losses inherent in the loan portfolio. We evaluate the need to establish reserves against losses on loans on a monthly basis. When additional reserves are necessary, a provision for loan losses is charged to earnings.

In connection with assessing the allowance, we have established a systematic methodology for determining the adequacy of the allowance for loan losses. The methodology utilizes a loan grading system which segments loans with similar risk characteristics. Management performs a monthly assessment of the allowance for loan losses based on the nature and volume of the loan portfolio, the amount of impaired and classified loans and historical loan loss experience. In addition, management considers other qualitative factors, including delinquency trends, economic conditions and loan considerations.

The Office of Thrift Supervision, as an integral part of its examination process, periodically reviews our allowance for loan losses. The Office of Thrift Supervision may require us to make additional provisions for loan losses based on judgments different from ours.

The allowance for loan losses decreased $119,000 to $1.8 million at June 30, 2008. Primarily as a result of growth in commercial loans and current economic conditions, the provision for loan losses was $451,000 for the year ended June 30, 2008, compared to a provision of $30,000 for the year ended June 30, 2007. Net charge-offs were $570,000 for fiscal 2008 compared to $247,000 for fiscal 2007. At June 30, 2008, our allowance for loan losses represented 0.65% of total gross loans and 610% of nonperforming loans, compared to 0.71% of total gross loans and 779% of nonperforming loans at June 30, 2007.

At June 30, 2007, our allowance for loan losses represented 0.71% of total gross loans and 779% of nonperforming loans, compared to 0.85% of total gross loans and 630% of nonperforming loans at June 30, 2006. The allowance for loan losses decreased $217,000 to $2.0 million at June 30, 2007.

Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance for loan losses may be necessary and results of operations could be adversely affected if circumstances differ substantially from the assumptions used in making the determinations. Furthermore, while we believe we have established our allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing our loan portfolio, will not request us to increase our allowance for loan losses. In addition, because future events affecting borrowers and collateral cannot be predicted with certainty, there can be no assurance that the existing allowance for loan losses is adequate or that increases will not be necessary should the quality of any loans deteriorate as a result of the factors discussed above. Any material increase in the allowance for loan losses may adversely affect our financial condition and results of operations.

Summary of Loan Loss Experience.The following table sets forth an analysis of the allowance for loan losses for the periods indicated. Where specific loan loss reserves have been established, any difference between the loss reserve and the amount of loss realized has been charged or credited to current income.

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	Year Ended June 30,
	2008			2007			2006			2005			2004
	(Dollars in thousands)
Allowance at beginning of period	$	1,955		$	2,172		$	2,293		$	2,479		$	2,841
Provision for loan losses		451			30			(68	)		—			—
Recoveries:
Real estate loans		28			32			29			47			60
Commercial business loans		12			30			45			52			53
Consumer loans		75			65			119			155			150
Total recoveries		115			127			193			254			263
Charge offs:
Real estate loans		(497	)		(159	)		(107	)		(180	)		(313	)
Commercial business loans		(30	)		(25	)		(2	)		(2	)		(82	)
Consumer loans		(158	)		(190	)		(137	)		(258	)		(230	)
Total charge-offs		(685	)		(374	)		(246	)		(440	)		(625	)
Net charge-offs		(570	)		(247	)		(53	)		(186	)		(362	)
Allowance at end of period	$	1,836		$	1,955		$	2,172		$	2,293		$	2,479
Allowance to nonperforming loans		609.97	%		778.88	%		629.57	%		538.26	%		228.90	%
Allowance to total gross loans outstanding at the end of the period		0.65	%		0.71	%		0.85	%		1.09	%		1.31	%
Net charge-offs to average loans outstanding during the period		0.20	%		0.09	%		0.02	%		0.09	%		0.19	%

The following table sets forth the breakdown of the allowance for loan losses by loan category at the dates indicated.

	At June 30,
	2008						2007
	Amount		% of Allowance to Total Allowance		% of Loans in Category to Total Loans		Amount		% of Allowance to Total Allowance		% of Loans in Category to Total Loans
Real estate	$	1,448	78.9	%	78.9	%	$	1,445	73.9	%	81.4	%
Commercial business		235	12.8		18.3			273	14.0		15.0
Consumer		153	8.3		2.8			237	12.1		3.6
Unallocated		—	—		—			—	—		N/A
Total allowance for loan losses	$	1,836	100.0	%	100.0	%	$	1,955	100.0	%	100.0	%

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	At June 30,
	2006						2005						2004
	Amount		% of Allowance to Total Allowance		% of Loans in Category to Total Loans		Amount		% of Allowance to Total Allowance		% of Loans in Category to Total Loans		Amount		% of Allowance to Total Allowance		% of Loans in Category to Total Loans
Real estate	$	1,649	75.9	%	81.6	%	$	1,981	86.4	%	80.0	%	$	2,108	85.0	%	90.2	%
Commercial business		454	20.9		13.9			250	10.9		16.4			193	7.8		6.7
Consumer		69	3.2		4.5			62	2.7		3.6			178	7.2		3.1
Unallocated		—	—		N/A			—	—		N/A			—	—		N/A
Total allowance for loan losses	$	2,172	100.0	%			$	2,293	100.0	%			$	2,479	100.0	%

Nonperforming and Classified Assets. When a loan becomes 90 days delinquent, the loan is placed on nonaccrual status at which time the accrual of interest ceases and the reserve for any uncollectible accrued interest is established and charged against operations. Typically, payments received on a nonaccrual loan are applied to the outstanding principal and interest as determined at the time of collection of the loan.

We consider repossessed assets and loans that are 90 days or more past due to be nonperforming assets. Real estate that we acquire as a result of foreclosure or by deed-in-lieu of foreclosure is classified as real estate owned until it is sold. When property is acquired, it is recorded at the lower of its cost, which is the unpaid balance of the loan plus foreclosure costs, or fair market value at the date of foreclosure. Holding costs and declines in fair value after acquisition of the property result in charges against income.

Nonperforming assets totaled $768,000, or 0.23% of total assets, at June 30, 2008, compared to $526,000, or 0.15% at June 30, 2007. Foreclosed real estate increased $187,000 to $462,000 at June 30, 2008. At June 30, 2008, foreclosed real estate consisted of $82,000 of single family homes and $380,000 of commercial real estate. Nonaccrual loans at June 30, 2008 included $139,000 of residential mortgage loans.

Under current accounting guidelines, a loan is defined as impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due under the contractual terms of the loan agreement. We consider consumer installment loans to be homogeneous and, therefore, do not separately evaluate them for impairment. All other loans are evaluated for impairment on an individual basis. At June 30, 2008, there were no loans classified as impaired.

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The following table provides information with respect to our nonperforming assets at the dates indicated. We did not have any troubled debt restructurings at the dates presented.

	At June 30,
	2008			2007			2006			2005			2004
	(Dollars in thousands)
Nonaccrual loans:
Real estate	$	139		$	251		$	296		$	426		$	1,047
Commercial business		162			—			49			—			15
Consumer		—			—			—			—			21
Total		301			251			345			426			1,083
Accruing loans past due 90 days or more		—			—			—			—			—
Total of nonaccrual and 90 days or more past due loans		301			251			345			426			1,083
Real estate owned		462			275			74			914			552
Other nonperforming assets(1)		5			—			16			—			—
Total nonperforming assets	$	768		$	526		$	435		$	1,340		$	1,635
Total nonperforming loans to total loans		0.11	%		0.09	%		0.13	%		0.20	%		0.58	%
Total nonperforming loans to total assets		0.09	%		0.07	%		0.11	%		0.14	%		0.35	%
Total nonperforming assets to total assets		0.23	%		0.15	%		0.13	%		0.45	%		0.54	%

(1) Consists primarily of repossessed automobiles and mobile homes.

Interest income that would have been recorded for the year ended June 30, 2008 and the year ended June 30, 2007 had nonaccruing loans been current according to their original terms amounted to $24,000 and $20,000, respectively. The amount of interest related to these loans included in interest income was $14,000 for the year ended June 30, 2008 and $15,000 for the year ended June 30, 2007.

Pursuant to federal regulations, we review and classify our assets on a regular basis. In addition, the Office of Thrift Supervision has the authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. “Substandard assets” must have one or more defined weaknesses and are characterized by the distinct possibility that we will sustain some loss if the deficiencies are not corrected. “Doubtful assets” have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified “loss” is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. The regulations also provide for a “special mention” category, described as assets which do not currently expose us to a sufficient degree of risk to warrant classification but do possess credit deficiencies or potential weaknesses deserving our close attention. When we classify an asset as substandard or doubtful we must establish a general allowance for loan losses. If we classify an asset as loss, we must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified loss or charge off such amount.

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The following table shows the aggregate amounts of our classified assets at the dates indicated.

	At June 30,
	2008		2007		2006
	(In thousands)
Substandard assets	$	3,490	$	4,784	$	5,370
Doubtful assets		—		—		—
Loss assets		—		—		—
Total classified assets	$	3,490	$	4,784	$	5,370

At each of the dates in the above table, substandard assets consisted of all nonperforming assets plus other loans that we believed exhibited weakness. These substandard but performing loans totaled $2.7 million, $4.3 million and $4.9 million at June 30, 2008, 2007 and 2006, respectively. At June 30, 2008, we also had $8.4 million of loans that we were monitoring because of concerns about the borrowers’ ability to continue to make payments in the future, none of which were nonperforming or classified as substandard. At that date, $625,000 of the allowance for loan losses related to those loans.

Delinquencies.The following table provides information about delinquencies in our loan portfolio at the dates indicated.

	At June 30,
	2008				2007				2006
	30-59 Days Past Due		60-89 Days Past Due		30-59 Days Past Due		60-89 Days Past Due		30-59 Days Past Due		60-89 Days Past Due
	(In thousands)
Real estate loans	$	1,296	$	109	$	1,338	$	1,220	$	828	$	145
Commercial business loans		520		—		24		—		396		171
Consumer loans		60		—		138		44		102		1
Total	$	1,876	$	109	$	1,500	$	1,264	$	1,326	$	317

At each of the dates in the above table, delinquent real estate loans consisted primarily of loans secured by residential real estate.

Liquidity and Capital Resources

Liquidity is the ability to meet current and future financial obligations of a short-term nature. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of investment securities and borrowings from the Federal Home Loan Bank of Cincinnati. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows and mortgage prepayments are greatly influenced by general interest rates, economic conditions and competition.

We regularly adjust our investments in liquid assets based upon our assessment of (1) expected loan demand, (2) expected deposit flows, (3) yields available on interest-earning deposits and securities and (4) the objectives of our asset/liability management program. Excess liquid assets are invested generally in interest-earning deposits and short- and intermediate-term U.S. Government agency obligations.

Our most liquid assets are cash and cash equivalents and interest-bearing deposits. The levels of these assets are dependent on our operating, financing, lending and investing activities during any given period. At June 30, 2008, cash and cash equivalents totaled $2.4 million and interest-bearing deposits totaled $15.2 million. Securities classified as available-for-sale, which provide additional sources of liquidity, totaled $3.5 million at June 30, 2008. In addition, at June 30, 2008, we had arranged the ability to borrow a total of approximately $49.3 million from the Federal Home Loan Bank of Cincinnati. On that date, we had advances outstanding of $33.0 million.

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At June 30, 2008, we had $1.8 million in loan commitments outstanding. In addition to commitments to originate loans, we had $5.9 million in loans-in-process primarily to fund undisbursed proceeds of construction loans, $8.0 million in unused standby letters of credit and $20.0 million in unused lines of credit. Certificates of deposit due within one year of June 30, 2008 totaled $99.3 million. We believe, based on past experience, that a significant portion of those deposits will remain with us. We have the ability to attract and retain deposits by adjusting the interest rates offered.

The following table presents certain of our contractual obligations as of June 30, 2008.

	Total		Payments due by period
Contractual Obligations			Less than 1 year		1-3 years		3-5 years		More than 5 years
	(In thousands)
Long-term debt obligations	$	33,000	$	—	$	16,000	$	17,000	$	—
Capital lease obligations		—		—		—		—		—
Operating lease obligations		81		30		37		14		—
Purchase obligations		185		185		—		—		—
Other long-term liabilities reflected on the balance sheet		—		—		—		—		—
Total	$	33,266	$	215	$	16,037	$	17,014	$	—

Our primary investing activities are the origination of loans and the purchase of securities. In the year ended June 30, 2008, we originated $164.0 million of loans. In fiscal 2007, we originated $161.4 million of loans. In fiscal 2006, we originated $161.9 million of loans and purchased $1.2 million of securities.

Financing activities consist primarily of activity in deposit accounts and Federal Home Loan Bank advances. We experienced a net increase in total deposits of $3.5 million in the year ended June 30, 2008, a net increase in total deposits of $21.2 million for the year ended June 30, 2007 and a net increase in total deposits of $4.1 million for the year ended June 30, 2006, respectively. Deposit flows are affected by the overall level of interest rates, the interest rates and products offered by us and our local competitors and other factors. We generally manage the pricing of our deposits to be competitive and to increase core deposit relationships. Occasionally, we offer promotional rates on certain deposit products in order to attract deposits. Federal Home Loan Bank advances were $33.0 million at June 30, 2008 and were $44.8 million and $52.4 million at June 30, 2007 and June 30, 2006, respectively.

We are subject to various regulatory capital requirements administered by the Office of Thrift Supervision, including a risk-based capital measure. The risk-based capital guidelines include both a definition of capital and a framework for calculating risk-weighted assets by assigning balance sheet assets and off-balance sheet items to broad risk categories. At June 30, 2008, we exceeded all of our regulatory capital requirements. We are considered “well capitalized” under regulatory guidelines. See “Regulation and Supervision—Federal Savings Institution Regulation—Capital Requirements.”

38

Off-Balance Sheet Arrangements

In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments, unused lines of credit, amounts due mortgagors on construction loans, amounts due on commercial loans and commercial letters of credit.

For the three months and year ended June 30, 2008, we engaged in no off-balance-sheet transactions reasonably likely to have a material effect on our financial condition, results of operations or cash flows.

Impact of New Accounting Pronouncements

The impact of new accounting pronouncements is discussed in Note 4 to the Company’s Audited Consolidated Financial Statements attached hereto and is incorporated by reference.

Effect of Inflation and Changing Prices

The financial statements and related financial data presented in this prospectus have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The primary impact of inflation on our operations is reflected in increased operating costs. Unlike most industrial companies, virtually all the assets and liabilities of a financial institution are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution’s performance than do general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Qualitative Aspects of Market Risk. Our most significant form of market risk is interest rate risk. We manage the interest rate sensitivity of our interest-bearing liabilities and interest-earning assets in an effort to minimize the adverse effects of changes in the interest rate environment. Deposit accounts typically react more quickly to changes in market interest rates than mortgage loans because of the shorter maturities of deposits. As a result, sharp increases in interest rates may adversely affect our earnings while decreases in interest rates may beneficially affect our earnings. To reduce the potential volatility of our earnings, we have sought to improve the match between asset and liability maturities and rates, while maintaining an acceptable interest rate spread. Pursuant to this strategy, we actively originate adjustable-rate mortgage loans for retention in our loan portfolio. These loans generally reprice beginning after five years and annually thereafter. Most of our residential adjustable-rate mortgage loans may not adjust downward below their initial interest rate. Although historically we have been successful in originating adjustable-rate mortgage loans, the ability to originate such loans depends to a great extent on market interest rates and borrowers’ preferences. This product enables us to compete in the fixed-rate mortgage market while maintaining a shorter maturity. Fixed-rate mortgage loans typically have an adverse effect on interest rate sensitivity compared to adjustable-rate loans. In recent years, we have used investment securities with terms of seven years or less and adjustable-rate mortgage-backed securities to help manage interest rate risk. We currently do not participate in hedging programs, interest rate swaps or other activities involving the use of off-balance sheet derivative financial instruments.

We have established an Asset/Liability Committee to communicate, coordinate and control all aspects involving asset/liability management. The committee establishes and monitors the volume and mix of assets and funding sources with the objective of managing assets and funding sources to produce results that are consistent with liquidity, capital adequacy, growth, risk limits and profitability goals.

Quantitative Aspects of Market Risk. We use an interest rate sensitivity analysis prepared by the Office of Thrift Supervision to review our level of interest rate risk. This analysis measures interest rate risk by computing changes in net portfolio value of our cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. Net portfolio value represents the market value of portfolio

39

equity and is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 100 to 300 basis point increase or 100 to 200 basis point decrease in market interest rates with no effect given to any steps that we might take to counter the effect of that interest rate movement. Because of the low level of market interest rates, this analysis is not performed for decreases of more than 200 basis points. We measure interest rate risk by modeling the changes in net portfolio value over a variety of interest rate scenarios.

The following table, which is based on information that we provide to the Office of Thrift Supervision, presents the change in our net portfolio value at June 30, 2008 that would occur in the event of an immediate change in interest rates based on Office of Thrift Supervision assumptions, with no effect given to any steps that we might take to counteract that change.

	Net Portfolio Value (Dollars in thousands)							Net Portfolio Value as % of Portfolio Value of Assets
Basis Point (“bp”) Change in Rates	Amount		$ Change			% Change		NPV Ratio		Change
300 bp	$	71,806	$	(2,217	)	(3	)%	21.50	%	(28	)bp
200		72,573		(1,450	)	(2	)	21.60		(18	)
100		73,131		(893	)	(1	)	21.64		(14	)
0		74,023		—		—		21.78		—
(100)		73,504		(519	)	(1	)	21.51		(27	)

The Office of Thrift Supervision uses certain assumptions in assessing the interest rate risk of savings associations. These assumptions relate to interest rates, loan prepayment rates, deposit decay rates and the market values of certain assets under differing interest rate scenarios, among others. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as adjustable-rate mortgage loans, have features that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could deviate significantly from those assumed in calculating the table.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

The financial statements required by this Item are incorporated by reference to the Company’s Audited Consolidated Financial Statements found on pages F-3 through F-30 hereto.

ITEM 9. CHANGE IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

None.

ITEM 9A. CONTROLS AND PROCEDURES

The Company’s management, including the Company’s principal executive officer and principal financial officer, have evaluated the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based upon their evaluation, the principal executive officer and 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 for the purpose of ensuring that the information required to be disclosed in the reports that the Company files or submits under the Exchange Act with the Securities and Exchange Commission (the “SEC”) (1) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and (2) is accumulated and

40

communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. In addition, based on that evaluation, no change in the Company’s internal control over financial reporting occurred during the quarter ended June 30, 2008 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

Management’s report on internal control over financial reporting is incorporated by reference to page F-1.

ITEM 9B. OTHER INFORMATION

None.

PART III

ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

The information relating to the directors and officers of Jefferson Bancshares and information regarding compliance with Section 16(a) of the Exchange Act is incorporated herein by reference to Jefferson Bancshares’ Proxy Statement for the 2008 Annual Meeting of Stockholders (the “Proxy Statement”) and to Part I, Item 1, “Description of Business—Executive Officers of the Registrant.” The information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated herein by reference to the section captioned “Other Information Relating to Directors and Executive Officers—Section 16(a) Beneficial Ownership Reporting Compliance” in the Proxy Statement.

Jefferson Bancshares has adopted a written code of ethics, which applies to our senior financial officers. We intend to disclose any changes or waivers from our Code of Ethics applicable to any senior financial officers on our website at http://www.jeffersonfederal.com or in a report on Form 8-K. A copy of the Code of Ethics is available, without charge, upon written request to Jane P. Hutton, Corporate Secretary, Jefferson Bancshares, Inc., 120 Evans Avenue, Morristown, Tennessee 37814.

ITEM 11. EXECUTIVE COMPENSATION

The information contained under the sections captioned “Executive Compensation” and “Director Compensation” in the Proxy Statement is incorporated herein by reference.

41

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERS MATTERS

(a) Security Ownership of Certain Beneficial Owners. The information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” in the Proxy Statement.

(b) Security Ownership of Management. The information required by this item is incorporated herein by reference to the section captioned “Stock Ownership” in the Proxy Statement.

(c) Changes in Control. Management of Jefferson Bancshares knows of no arrangements, including any pledge by any person of securities of Jefferson Bancshares, the operation of which may at a subsequent date result in a change in control of the registrant.

(d) Equity Compensation Plan Information.

The following table provides information as of June 30, 2008 for compensation plans under which equity securities may be issued. Jefferson Bancshares does not maintain any equity compensation plans that have not been approved by security holders.

Plan category	Number of securities to be issued upon exercise of outstanding options, warrants and rights (a)	Weighted-average exercise price of outstanding options, warrants and rights (b)		Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a)) (c)
Equity compensation plans approved by security holders	400,032	$	13.69	298,718
Equity compensation plans not approved by security holders	—		—	—
Total	400,032	$	13.69	298,718

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

The information required by this item relating to certain relationships and related transactions is incorporated herein by reference to the section captioned “Other Information Relating to Directors and Executive Officers—Transactions with Management” in the Proxy Statement. The information required by this item relating to director independence is incorporated herein by reference to the section captioned “Items to Be Voted Upon By Shareholders—Item I—Election of Directors” in the Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this item is incorporated herein by reference to the section captioned “Items to Be Voted Upon By Shareholders—Item 2—Ratification of Independent Registered Public Accounting Firm” in the Proxy Statement.

42

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

(a) (1) The exhibits and financial statement schedules filed as a part of this report are as follows:

• Report of Independent Registered Public Accounting Firm.

• Consolidated Balance Sheets for the Years Ended June 30, 2008 and 2007.

• Consolidated Statements of Earnings for the Years Ended June 30, 2008 and 2007.

• Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended June 30, 2008 and 2007.

• Consolidated Statements of Cash Flows for the Years Ended June 30, 2008 and 2007.

• Notes to Consolidated Financial Statements.

(2) All schedules are omitted as the required information either is not applicable or is included in the financial statements or related notes.

(3) Exhibits

3.1		Charter of Jefferson Bancshares, Inc. (1)
3.2		Bylaws of Jefferson Bancshares, Inc. (2)
4.0		Specimen Stock Certificate of Jefferson Bancshares, Inc. (1)
10.1	*	Employment Agreement between Anderson L. Smith, Jefferson Bancshares, Inc. and Jefferson Federal Bank (3)
10.2	*	Amendment to Employment Agreement between Anderson L. Smith, Jefferson Bancshares, Inc. and Jefferson Federal Bank (4)
10.3	*	Jefferson Federal Savings and Loan Association of Morristown Employee Severance Compensation Plan (1)
10.4	*	1995 Jefferson Federal Savings and Loan Association of Morristown Stock Option Plan (1)
10.5	*	Jefferson Federal Bank Supplemental Executive Retirement Plan (1)
10.6	*	Jefferson Bancshares, Inc. 2004 Stock-Based Incentive Plan (5)
11.0		Statement re: computation of per share earnings (6)
21.0		List of Subsidiaries
23.0		Consent of Craine, Thompson & Jones, P.C.
31.1		Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
31.2		Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32.0		Section 1350 Certifications

* Management contract or compensatory plan, contract or arrangement.

(1) Incorporated herein by reference from the Exhibits to Form S-1, Registration Statement and amendments thereto, initially filed on March 21, 2003, Registration No. 333-103961.

(2) Incorporated herein by reference from the Exhibits to the Current Report on Form 8-K, filed on October 26, 2007.

(3) Incorporated herein by reference from the Exhibits to the Annual Report on Form 10-K, filed on September 29, 2003.

(4) Incorporated herein by reference from the Exhibits to the Annual Report on Form 10-K, filed on September 13, 2004.

(5) Incorporated herein by reference from Appendix A to the Company’s definitive proxy statement filed on December 1, 2003.

(6) Incorporated herein by reference to Note 3 to the Company’s Audited Financial Statements found on page F-13.

43

SIGNATURES

In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	JEFFERSON BANCSHARES, INC.
Date: September 11, 2008	By:	/s/ Anderson L. Smith
		Anderson L. Smith
		President, Chief Executive Officer and Director

In accordance with the Exchange Act, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Name	Title	Date
/s/ Anderson L. Smith	President, Chief Executive Officer and Director (principal executive officer)	September 11, 2008
Anderson L. Smith
/s/ Jane P. Hutton Jane P. Hutton	Chief Financial Officer, Treasurer and Secretary (principal financial and accounting officer)	September 11, 2008
/s/ John F. McCrary, Jr.	Director	September 11, 2008
John F. McCrary, Jr.
/s/ H. Scott Reams	Director	September 11, 2008
H. Scott Reams
/s/ Dr. Jack E. Campbell	Director	September 11, 2008
Dr. Jack E. Campbell
/s/ Dr. Terry M. Brimer	Director	September 11, 2008
Dr. Terry M. Brimer
/s/ William F. Young	Director	September 11, 2008
William F. Young
/s/ William T. Hale	Director	September 11, 2008
William T. Hale

REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external reporting purposes in accordance with accounting principles generally accepted in the United States. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. The Company’s management conducted an evaluation of the effectiveness of internal control over financial reporting as of June 30, 2008 based on the framework in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). Based on this evaluation, management concluded that internal control over financial reporting was effective as of June 30, 2008 based on the specified criteria. Craine, Thompson & Jones, P.C., an independent registered public accounting firm, has audited the Company’s Consolidated Financial Statements included in this Annual Report on Form 10-K and, as part of their audit, has issued an attestation report on the Company’s internal control over financial reporting. See “Report of Independent Registered Public Accounting Firm” on page F-2.

F-1

[Letterhead of Craine, Thompson, & Jones, P.C.]

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors and Stockholders

Jefferson Bancshares, Inc.

We have audited Jefferson Bancshares, Inc.’s internal control over financial reporting as of June 30, 2008, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Jefferson Bancshares Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Form 10-K. Our responsibility is to express an opinion on the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Jefferson Bancshares, Inc. maintained, in all material respects, effective internal control over financial reporting as of June 30, 2008, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the balance sheets and the related statements of income, stockholders’ equity and comprehensive income, and cash flows of Jefferson Bancshares, Inc., and our report dated September 2, 2008, expressed an unqualified opinion.

/s/ Craine, Thompson, & Jones, P.C.

Morristown, Tennessee

September 2, 2008

F-2

[Letterhead of Craine, Thompson, & Jones, P.C.]

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Board of Directors

Jefferson Bancshares, Inc. and Subsidiary

Morristown, Tennessee

We have audited the accompanying consolidated balance sheets of Jefferson Bancshares, Inc. and Subsidiary as of June 30, 2008 and 2007, and the related consolidated statements of earnings, changes in stockholders’ equity and cash flows for each of the years then ended. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Jefferson Bancshares, Inc. and Subsidiary as of June 30, 2008 and 2007, and the results of its operations and its cash flows for the years then ended, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Jefferson Bancshares, Inc. and Subsidiary’s internal control over financial reporting as of June 30, 2008, based on criteria established inInternal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated September 2, 2008, expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.

/s/ Craine, Thompson, & Jones, P.C.

Morristown, Tennessee

September 2, 2008

F-3

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Consolidated Balance Sheets

(Dollars in Thousands)

	June 30,
	2008			2007
Assets
Cash and cash equivalents	$	2,398		$	1,955
Interest-bearing deposits		14,112			4,802
Fed funds sold		1,106			977
Investment securities classified as available for sale, net		3,478			27,278
Federal Home Loan Bank stock		1,868			1,796
Bank owned life insurance		5,926			5,702
Loans receivable, net of allowance for loan losses of $1,836 and $1,955		282,483			274,881
Loans held-for-sale		258			2,468
Premises and equipment, net		15,200			15,572
Foreclosed real estate, net		462			275
Accrued interest receivable:
Investments		38			299
Loans receivable, net		1,208			1,414
Deferred tax asset		844			1,606
Other assets		884			678
Total assets	$	330,265		$	339,703
Liabilities and Stockholders’ Equity
Deposits:
Noninterest-bearing	$	17,517		$	12,561
Interest-bearing		206,035			207,521
Federal Home Loan Bank advances		33,000			44,800
Other liabilities		836			1,120
Accrued income taxes		100			57
Total liabilities		257,488			266,059
Commitments and contingent liabilities		—			—
Stockholders’ equity:
Preferred stock, $0.01 par value; 10,000,000 shares authorized; shares issued and outstanding—none		—			—
Common stock, $0.01 par value; 30,000,000 shares authorized; 8,446,375 shares issued and 6,207,702 and 6,411,586 outstanding at June 30, 2008 and 2007, respectively		84			84
Additional paid-in capital		72,959			72,738
Unearned ESOP shares		(4,537	)		(4,969	)
Unearned compensation		(1,659	)		(2,182	)
Accumulated other comprehensive income		(17	)		(246	)
Retained earnings		34,965			35,082
Treasury stock, at cost (2,238,673 and 2,034,789 shares)		(29,018	)		(26,863	)
Total stockholders’ equity		72,777			73,644
Total liabilities and stockholders’ equity	$	330,265		$	339,703

The accompanying notes are an integral part of these consolidated financial statements.

F-4

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Earnings

(Dollars in Thousands Except Per Share Amounts)

	Years Ended June 30,
	2008		2007
Interest income:
Interest on loans receivable	$	19,782	$	19,605
Interest on investment securities		733		1,118
Other interest		331		281
Total interest income		20,846		21,004
Interest expense:
Deposits		7,665		7,334
Advances from FHLB		1,583		2,326
Total interest expense		9,248		9,660
Net interest income		11,598		11,344
Increase in loan loss allowance		451		30
Net interest income after provision for loan losses		11,147		11,314
Noninterest income:
Dividends		36		69
Mortgage origination income		338		451
Service charges and fees		768		522
Gain on sale of fixed assets		1		—
Gain (loss) on sale of investment securities, net		—		(29	)
Gain on sale of foreclosed real estate, net		51		39
Increase in BOLI cash value		224		211
Other		102		92
Total noninterest income		1,520		1,355
Noninterest expense:
Compensation and benefits		5,518		6,011
Occupancy expense		702		572
Equipment and data processing expenses		1,458		1,377
DIF deposit insurance premium		26		25
Advertising		246		324
Other		1,939		1,761
Total noninterest expense		9,889		10,070
Earnings before income taxes		2,778		2,599
Income taxes:
Current		911		753
Deferred		620		155
Total income taxes		1,531		908
Net earnings	$	1,247	$	1,691
Net earnings per common share—basic	$	0.22	$	0.28
Net earnings per common share—diluted	$	0.22	$	0.28

The accompanying notes are an integral part of these consolidated financial statements.

F-5

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Changes in Stockholders’ Equity

(Dollars in Thousands)

	Common Stock		Additional Paid-in Capital			Unallocated Common Stock in ESOP			Unearned Compensation			Accumulated Other Comprehensive Income			Retained Earnings			Treasury Stock			Total Stockholders’ Equity
Balance at June 30, 2006	$	84	$	72,171		$	(5,401	)	$	(2,733	)	$	(609	)	$	34,780		$	(23,749	)	$	74,543
Comprehensive income:
Net earnings		—		—			—			—			—			1,691			—			1,691
Change in net unrealized gain (loss) on securities available for sale, net of taxes of $225		—		—			—			—			363			—			—			363
Total comprehensive income		—		—			—			—			—			—			—			2,054
Dividends		—		—			—			—			—			(1,558	)		—			(1,558	)
Dividends used for ESOP payment		—		—			—			—			—			149			—			149
Dividends used for MRP and ESOP expenses		—		—			—			—			—			20			—			20
Shares committed to be released by the ESOP		—		119			432			—			—			—			—			551
Stock options expensed		—		265			—			—			—			—			—			265
Earned portion of stock grants		—		—			—			551			—			—			—			551
MRP Vesting		—		(23	)		—			—			—			—			—			(23	)
Exercise of options		—		160			—			—			—			—			—			160
Tax benefit from exercise of nonqualifying stock options		—		46			—			—			—			—			—			46
Purchase of common stock (241,698 shares)		—		—			—			—			—			—			(3,114	)		(3,114	)
Balance at June 30, 2007		84		72,738			(4,969	)		(2,182	)		(246	)		35,082			(26,863	)		73,644
Comprehensive income:
Net earnings		—		—			—			—			—			1,247			—			1,247
Change in net unrealized gain (loss) on securities available for sale, net of taxes of $142		—		—			—			—			229			—			—			229
Total comprehensive income		—		—			—			—			—			—			—			1,476
Dividends		—		—			—			—			—			(1,508	)		—			(1,508	)
Dividends used for ESOP payment		—		—			—			—			—			124			—			124
Dividends used for MRP and ESOP expenses		—		—			—			—			—			20			—			20
Shares committed to be released by the ESOP		—		11			432			—			—			—			—			443
Stock options expensed		—		262			—			—			—			—			—			262
Earned portion of stock grants		—		—			—			523			—			—			—			523
MRP Vesting		—		(52	)		—			—			—			—			—			(52	)
Purchase of common stock (203,884 shares)		—		—			—			—			—			—			(2,155	)		(2,155	)
Balance at June 30, 2008	$	84	$	72,959		$	(4,537	)	$	(1,659	)	$	(17	)	$	34,965		$	(29,018	)	$	72,777

The accompanying notes are an integral part of these consolidated financial statements.

F-6

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Cash Flows

(Dollars in Thousands)

	Years Ended June 30,
	2008			2007
Cash flows from operating activities:
Net earnings	$	1,247		$	1,691
Adjustments to reconcile net earnings to net cash provided by (used for) operating activities:
Allocated ESOP shares		443			551
Depreciation and amortization expense		658			536
Amortization of premiums (discounts), net investment securities		14			15
Provision for loan losses		451			30
Gain on sale of fixed assets		(1	)		—
Loss on sale of investment securities, net		—			29
FHLB stock dividends		(49	)		(52	)
Amortization of deferred loan fees, net		(261	)		(181	)
Gain on foreclosed real estate, net		(51	)		(39	)
Deferred tax expense		620			155
Tax benefit from stock options and MRP		—			46
Earned portion of MRP		522			551
Origination of mortgage loans held for sale		(21,165	)		(49,502	)
Proceeds from sales of mortgage loans		23,375			48,679
Increase in cash value of life insurance		(224	)		(211	)
Stock options expensed		262			265
Decrease (increase) in:
Accrued interest receivable		467			(41	)
Other assets		(206	)		3,992
Increase in other liabilities and accrued income taxes		(229	)		3
Net cash provided by operating activities		5,873			6,517
Cash flows from investing activities:
Loan originations, net of principal collections		(8,082	)		(20,615	)
Purchase of Federal Home Loan Bank stock		(23	)		—
Proceeds from sale of available-for-sale securities		1,000			3,965
Proceeds from maturities, calls, and prepayments		23,157			1,145
Proceeds from sale of fixed assets		1			—
Purchase of premises and equipment		(286	)		(4,182	)
Proceeds from sale of foreclosed real estate, net		247			(2	)
Net cash provided by (used in) investing activities		16,014			(19,689	)

(continued)

F-7

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Consolidated Statements of Cash Flows

(Dollars in Thousands)

	Years Ended June 30,
	2008				2007
Cash flows from financing activities:
Net increase (decrease) in deposits	$	3,470			$	21,239
Proceeds from advances from FHLB		45,100		��		89,500
Repayment of FHLB advances		(56,900	)			(97,100	)
Purchase of treasury stock		(2,155	)			(3,114	)
Proceeds from exercise of stock options		—				160
Dividends paid		(1,520	)			(1,735	)
Net cash (used in) provided by financing activities		(12,005	)			8,950
Net increase (decrease) in cash and cash equivalents, and interest-bearing deposits		9,882				(4,222	)
Cash, cash equivalents, and interest-bearing deposits at beginning of period		7,734				11,956
Cash and cash equivalents at end of year	$	17,616			$	7,734
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest on deposits and advances	$	9,350			$	9,660
Income taxes	$	1,060			$	720
Real estate acquired in settlement of loans	$	1,564			$	275

The accompanying notes are an integral part of these consolidated financial statements.

F-8

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

June 30, 2008 and 2007

(Dollars in Thousands)

NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

On July 1, 2004, Jefferson Bancshares, M.H.C. (the M.H.C.) and Jefferson Federal Savings and Loan Association of Morristown (the Association) completed a conversion from the mutual holding company form of organization into the stock holding company form of organization. A newly organized Tennessee corporation, Jefferson Bancshares, Inc. (the Company), was formed to become the holding company for the Association. The Company sold 6.6 million shares at $10.00 per share and commenced trading on the NASDAQ Global Market under the symbol JFBI.

During the process of conversion, the Association changed its name to Jefferson Federal Bank (the Bank). The Company provides a variety of financial services to individuals and small businesses through its offices in Upper East Tennessee. Its primary deposit products are transaction accounts and term certificate accounts and its lending products are commercial and residential mortgages and, to a lesser extent, consumer loans.

Principles of Consolidation - The consolidated financial statements include the accounts of Jefferson Bancshares, Inc. and its wholly owned subsidiary, Jefferson Federal Bank. All significant intercompany balances and transactions have been eliminated in consolidation.

Use of Estimates - In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the statement of condition dates and revenues and expenses for the periods shown. Actual results could differ from the estimates and assumptions used in the consolidated financial statements. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, and deferred tax assets.

Significant Group Concentrations of Credit Risk - The Company originates residential real estate loans and, to a lesser extent, commercial real estate and consumer loans primarily to customers located in Upper East Tennessee. The ability of the Company’s debtors to honor their contracts is dependent upon the real estate and general economic conditions in this area.

Significant Accounting Policies - The following comprise the significant accounting policies, which the Company follows in preparing and presenting its consolidated financial statements:

a. For purposes of reporting cash flows, cash and cash equivalents include cash and balances due from depository institutions, interest-bearing deposits in other depository institutions and fed funds sold with original maturities of three months or less. Interest-bearing deposits in other depository institutions were $15,218 and $5,779 at June 30, 2008 and 2007, respectively.

b. Investments in debt securities are classified as “held-to-maturity” or “available-for-sale” according to the Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standard (SFAS) No. 115. Investments classified as “held-to-maturity” are carried at cost while those identified as “available-for-sale” are carried at fair value. All securities are adjusted for amortization of premiums and accretion of discounts over the term of the security using the interest method. Management has the positive intent and ability to carry those securities classified as “held-to-maturity” to maturity for long-term investment purposes and, accordingly, such securities are not adjusted for temporary declines in market value. “Available-for-sale” securities are adjusted for changes in fair value through a direct entry to a separate component of stockholders’ equity (i.e., other comprehensive income). Investments in equity securities are carried at the lower of cost or market. The cost of securities sold is determined by specific identification.

F-9

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

c. Loans receivable, net, which management has the intent and ability to hold until maturity or pay-off, are generally carried at unpaid principal balances less loans in process, net deferred loan fees, unearned discount on loans and allowances for losses. Loan origination and commitment fees and certain direct loan origination costs are deferred and amortized to interest income over the contractual life of the loan using the interest method.

The accrual of interest on all loans is discontinued at the time the loan is 90 days delinquent. All interest accrued but not collected for loans considered impaired, placed on non-accrual or charged off is reversed against interest income. The interest on these loans is accounted for on the cash basis or cost-recovery method until the loan is returned to accrual status. Loans are returned to accrual status when future payments are reasonably assured.

d. Beginning in January 2005, the Company began originating mortgage loans conforming to guidelines for sale in the secondary mortgage market. Because commitment letters are only given to the borrower after an underwriter agrees to purchase the loan according to the stated terms, the Company’s maximum time between funding the loan and completing the sale to the underwriter is generally three weeks. The loans are carried at the lower of aggregate cost or fair market value as determined by the amount committed to by the underwriter. The loans are sold without recourse and the mortgage servicing rights are sold as part of the loan package.

e. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Subsequent recoveries, if any, are credited to the allowance.

The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective, as it requires estimates that are susceptible to significant revision as more information becomes available. The Company is subject to periodic examination by regulatory agencies, which may require the Company to record increases in the allowances based on the regulator’s evaluation of available information. There can be no assurance that the Company’s regulators will not require further increases to the allowances.

The allowance consists of specific, general and minimum components. The specific component relates to loans that are classified as doubtful, substandard or special mention. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. A minimum component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The minimum component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.

Specific valuation allowances are established for impaired loans. The Company considers a loan to be impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement on a timely basis. The types of loans for which impairment is measured include non-accrual income property loans (excluding those loans included in the homogeneous portfolio which are collectively reviewed for impairment), large non-accrual single-family loans and troubled debt restructuring. Such loans are placed on non-accrual status at the point deemed uncollectible and impairment is measured by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of collateral if the loan is collateral dependent. Impairment losses are recognized through an increase in the allowance for loan losses.

F-10

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

f. Credit related financial instruments arising in the ordinary course of business consist primarily of commitments to extend credit. Such financial instruments are recorded when they are funded.

g. Premises and equipment are carried at cost, less accumulated depreciation. Expenditures for assets with a life greater than one year and costing more than $1,000 are generally capitalized. Depreciation of premises and equipment is computed using the straight-line and accelerated methods based on the estimated useful lives of the related assets. Estimated lives for buildings, leasehold improvements, equipment and furniture are thirty-nine, thirty-nine, five and seven years, respectively. Estimated lives for building improvements are evaluated on a case-by-case basis and depreciated over the estimated remaining life of the improvement.

h. Foreclosed real estate is initially recorded, and subsequently carried, at the lower of cost or fair value less estimated selling costs. Costs related to improvement of foreclosed real estate are capitalized.

i. Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various balance sheet assets and liabilities and gives current recognition to changes in tax rates and laws.

j. Effective July 1, 2005, the Company adopted Statement of Financial Standards No. 123RShare Based Payment which is an amendment of FASB Statement No. 123 (SFAS 123),Accounting for Stock-Based Compensation.This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award—the requisite service period.

The Company adopted SFAS 123R using the modified prospective application transition method. This method requires the Company to expense the unvested portion of options granted in 2004, which reduces net earnings by approximately $214, net of taxes for the fiscal year ending June 30, 2008 and by approximately $106 in the remaining requisite service period. SFAS 123R provides for the use of alternative models to determine compensation cost related to stock option grants. The Company has determined the estimated fair value of stock options at grant date using the Black-Scholes option-pricing model based on market data as of January 29, 2004. The expected dividend yield of 1.17% and expected volatility of 7.01% were used to model the value. The risk free rate of return equaled 4.22%, which was based on the yield of a U.S. Treasury note with a term of ten years. The estimated time remaining before the expiration of the options equaled ten years.

F-11

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 1 – NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

k. The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and due from banks and interest-bearing deposits with banks - For cash and related instruments, the carrying amount is a reasonable estimate of fair value.

Available-for-sale and held-to-maturity securities - Fair values for securities, excluding restricted equity securities, are based on quoted market prices. The carrying values of restricted equity securities approximate fair value.

Loans receivable - The fair value of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Loans Held-For-Sale - Since mortgage loans originated for sale in the secondary market are pre-committed to by the underwriter prior to a commitment letter being sent to the borrower and there is generally a three week maximum time interval between funding the loan and the sale to the underwriter, the carrying amount of the loans held-for-sale approximate fair value.

Accrued interest receivable - The carrying amount is a reasonable estimate of fair value for accrued interest receivable.

Deposit liabilities - The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value of fixed maturity certificates of deposit is estimated using the rates currently offered for deposits of similar remaining maturities.

Short-term borrowings - The carrying amounts of short-term borrowings maturing within 90 days approximate their fair values. Fair values of other short-term borrowings are estimated using discounted cash flow analysis based on the Company’s current incremental borrowing rates for similar types of borrowing arrangements.

Off-balance-sheet instruments - Fair values for off-balance-sheet lending commitments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counter-parties’ credit standings.

Segment Reporting - The Company’s operations are solely in the financial services industry and include providing to its customers traditional banking and other financial services. The Company operates primarily in Upper East Tennessee. Management makes operating decisions and assesses performance based on an ongoing review of the Company’s financial results. Therefore, the Company has a single operating segment for financial reporting purposes.

NOTE 2 – RESTRICTIONS ON CASH AND AMOUNTS DUE FROM BANKS

The Bank is required to maintain average balances on hand or with the Federal Home Loan Bank and Federal Reserve Bank. At June 30, 2008 and 2007, these reserve balances amounted to $1,273 and $1,067, respectively.

F-12

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 3 – EARNINGS PER SHARE

Earnings per common share and earnings per common share-assuming dilution have been computed on the basis of dividing net earnings by the weighted-average number of shares of common stock outstanding. Diluted earnings per common share reflect additional common shares that would have been outstanding if dilutive potential common shares had been issued. Potential common shares that may be issued by the Company relate solely to outstanding stock options and are determined using the treasury stock method. Calculations related to earnings per share are provided in the following table.

	Years Ending June 30,
	2008	2007
Weighted average number of common shares used in computing basic earnings per common share	5,717,375	5,977,094
Effect of dilutive stock options	—	—
Weighted average number of common shares and dilutive potential common shares used in computing earnings per common share assuming dilution	5,717,375	5,977,094

NOTE 4 – IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS

Disclosures for Derivative Instruments and Hedging Activities - In March 2008, the FASB issued Statement No. 161,Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No. 133. The FASB issued this statement in response to concerns that current disclosures related to derivative instruments and hedging activities do not provide adequate information about how these activities affect an entity’s financial position, financial performance, and cash flows. As such, this Statement requires enhanced disclosures about an entity’s derivative and hedging activities and thereby improves the transparency of financial reporting. This Statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company does not anticipate that this Statement would have any material impact on the consolidated financial statements.

Fair Value Option for Financial Assets and Financial Liabilities - In February 2007, the FASB issued Statement No. 159,Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115. This Statement permits entities to choose to measure many financial instruments and certain other items at fair value at specified election dates. The Statement also provides guidance on financial assets and liabilities that are not subject to fair value measurement. The Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted provided that the entity also elects to apply the provisions of FASB Statement No. 157,Fair Value Measurements. The Company does not anticipate that this Statement would have any material impact on the consolidated financial statements.

F-13

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 4 – IMPACT OF NEW ACCOUNTING PRONOUNCEMENTS (CONTINUED)

Fair Value Measurements -In September 2006, the FASB issued Statement No. 157,Fair Value Measurements as an amendment to several Accounting Principles Board Opinions, FASB Statements and one FASB Interpretation. The Statement defines fair value, provides a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. The Statement is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company expects that its disclosures regarding measurement of fair value will be expanded, but does not anticipate that there would be any other material impact on the consolidated financial statements.

NOTE 5 – INVESTMENT SECURITIES

Investment securities are summarized as follows:

	June 30, 2008
	Amortized Cost			Unrealized Gains		Unrealized Losses			Fair Value
Securities Available-for-Sale
Debt securities:
Federal agency	$	—		$	—	$	—		$	—
Municipals		3,506			7		(35	)		3,478
Total securities available-for-sale	$	3,506		$	7	$	(35	)	$	3,478
Weighted-average rate		3.62	%
	June 30, 2007
	Amortized Cost			Unrealized Gains		Unrealized Losses			Fair Value
Securities Available-for-Sale
Debt securities:
Federal agency	$	23,339		$	—	$	(278	)	$	23,061
Municipals		4,338			1		(122	)		4,217
Total securities available-for-sale	$	27,677		$	1	$	(400	)	$	27,278
Weighted-average rate		3.96	%

Investment securities with a carrying value of $0 and $4,950 were pledged to secure public funds and/or advances from the Federal Home Loan Bank at June 30, 2008 and 2007, respectively.

F-14

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 5 – INVESTMENT SECURITIES (CONTINUED)

Securities with unrealized losses not recognized in income are as follows:

	Less than 12 Months					12 Months or More					Total
	Fair Value		Unrealized Losses			Fair Value		Unrealized Losses			Fair Value		Unrealized Losses
June 30, 2008
Federal agency	$	—	$	—		$	—	$	—		$	—	$	—
Municipals		2,417		(35	)		—		—			2,417		(35	)
	$	2,417	$	(35	)	$	—	$	—		$	2,417	$	(35	)
June 30, 2007
Federal agency	$	—	$	—		$	23,061	$	(278	)	$	23,061	$	(278	)
Municipals		—		—			4,106		(122	)		4,106		(122	)
	$	—	$	—		$	27,167	$	(400	)	$	27,167	$	(400	)

The Company evaluates its securities with significant declines in fair value on a quarterly basis to determine whether they should be considered temporarily or other than temporarily impaired. The unrealized losses on investments are attributable to changes in interest rates, rather than credit quality. Since the Company has the ability and intent to hold these investments until a market price recovery or maturity, these investments are not considered impaired on an other-than-temporary basis.

Maturities of debt securities at June 30, 2008, are summarized as follows:

	Available-for-Sale				Weighted Average Yield
	Amortized Cost		Fair Value
Within 1 year	$	377	$	377	3.26	%
Over 1 year through 5 years		1,229		1,226	3.19	%
After 5 years through 10 years		1,423		1,401	3.88	%
Over 10 years		477		474	4.28	%
	$	3,506	$	3,478	3.62	%

Proceeds from sale of debt securities and gross realized gains and losses on these sales are summarized as follows:

	Year Ended June 30,
	2008		2007
Proceeds from sales	$	1,000	$	3,965
Gross realized gains	$	—	$	6
Gross realized losses		—		(35	)
Net gains (losses)	$	—	$	(29	)

F-15

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 6 – LOANS RECEIVABLE, NET

Loans receivable, net are summarized as follows:

	June 30,
	2008			2007
Real estate loans:
Residential 1-4 family	$	63,340		$	69,693
Home equity lines of credit		5,723			5,470
Multi-family		4,219			8,182
Construction		19,553			21,634
Commercial		90,933			86,929
Land		40,862			33,604
Total real estate loans		224,630			225,512
Commercial business loans		52,037			41,667
Consumer loans:
Automobile loans		3,973			6,423
Mobile home loans		60			82
Loans secured by deposits		930			978
Other consumer loans		2,961			2,540
Total consumer loans		7,924			10,023
Sub-total		284,591			277,202
Less:
Deferred loan fees, net		(272	)		(366	)
Allowance for losses		(1,836	)		(1,955	)
Loans, net	$	282,483		$	274,881
Weighted-average rate		6.33	%		7.34	%
The following is a summary of information pertaining to impaired and non-accrual loans:
	June 30,
	2008			2007
Total impaired loans	$	—		$	—
Valuation allowance for impaired loans	$	—		$	—
Total non-accrual loans	$	301		$	251

F-16

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 6 – LOANS RECEIVABLE, NET (CONTINUED)

	Years Ended June 30,
	2008		2007
Average investment in impaired loans	$	—	$	38
Interest income recognized on impaired loans	$	—	$	—

No additional funds are committed to be advanced in connection with impaired loans.

Commercial real estate loans are secured principally by office buildings, shopping centers, churches and other rental real estate. Construction loans are secured by commercial real estate and single-family dwellings.

Following is a summary of activity in allowance for losses:

	Years Ended June 30,
	2008			2007
Balance, beginning of period	$	1,955		$	2,172
Loans charged-off		(684	)		(374	)
Recoveries		114			127
Provision for loan losses		451			30
Balance, end of period	$	1,836		$	1,955

Following is a summary of loans to directors, executive officers and associates of such persons:

Balance, June 30, 2007	$	7,772
Additions		—
Repayment		(878	)
Balance, June 30, 2008	$	6,894

These loans were made on substantially the same terms as those prevailing at the time for comparable transactions with unaffiliated persons.

F-17

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 7 – PREMISES AND EQUIPMENT, NET

Premises and equipment, net are summarized as follows:

	June 30,
	2008		2007
Land	$	3,324	$	3,363
Office building		12,460		12,233
Leasehold improvements		74		74
Furniture and equipment		3,351		3,254
		19,209		18,924
Less accumulated depreciation and amortization		4,009		3,352
	$	15,200	$	15,572

Depreciation and amortization expense for the years ended June 30, 2008 and 2007 was $658 and $536, respectively.

Pursuant to the terms of non-cancelable lease agreements in effect at June 30, 2008, pertaining to real property, future minimum payments are as follows:

For the year ended June 30,
2009	$	30
2010		18
2011		19
2012		14
2013		14
Total	$	95

Lease expense for June 30, 2008 and 2007 was $30 and $95, respectively.

The Company has also entered into a service contract for data processing services. Future minimum payments under this agreement are as follows:

For the year ended June 30,
2009	$	185
Total	$	185

Data processing service expense for June 30, 2008 and 2007 was $577 and $569, respectively.

F-18

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 8 – DEPOSITS

Deposits are summarized as follows:

	June 30,
	2008			2007
Description and Interest Rate
Noninterest-bearing NOW accounts	$	17,517		$	12,561
NOW accounts, 0.50%		20,352			16,230
Passbook accounts, 0.59%		9,153			9,690
Money market deposit accounts, 2.20% and 3.76%, respectively		49,781			41,312
Total transaction accounts		96,803			79,793
Certificates:
1.01 - 2.00%		2,234			—
2.01 - 3.00%		25,351			1,410
3.01 - 4.00%		60,067			12,888
4.01 - 5.00%		33,608			86,676
5.01 - 6.00%		5,489			39,315
Total certificates, 3.62% and 4.49%, respectively		126,749			140,289
Total deposits	$	223,552		$	220,082
Weighted-average rate-deposits		2.60	%		3.60	%

The aggregate amount of time deposits in denominations of $100,000 or more was $43,472 and $45,913, respectively, at June 30, 2008 and 2007.

The Deposit Insurance Fund, as administrated by the Federal Deposit Insurance Corporation, insures deposits up to applicable limits. Deposit amounts in excess of $100,000 are generally not federally insured.

The total amount of overdrafts reclassified as loans was $78 and $77, respectively, at June 30, 2008 and 2007.

At June 30, 2008, the scheduled maturities of time deposits are as follows:

2009	$	99,266
2010		7,166
2011		19,748
2012		569
Total	$	126,749

F-19

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 8 – DEPOSITS (CONTINUED)

Following is a summary of interest on deposits:

	Years Ended June 30,
	2008		2007
NOW	$	104	$	84
Passbook accounts		49		51
Money market deposit accounts		1,399		1,394
Certificates		6,113		5,805
		7,665		7,334
Less—early withdrawal penalties		—		—
	$	7,665	$	7,334

NOTE 9 – FHLB ADVANCE

Pursuant to collateral agreements with the Federal Home Loan Bank (“FHLB”), advances are secured by a Blanket Mortgage Collateral Agreement. The Agreement pledges the entire one-to-four family residential mortgage portfolio and allows a maximum advance of $49,266 at June 30, 2008. Outstanding advances were $33,000 and $44,800 at June 30, 2008 and 2007, respectively.

NOTE 10 – INCOME TAXES

In computing federal income tax, savings institutions treated as small banks for tax years beginning before 1996 were allowed a statutory bad debt deduction based on specified experience formulas or 8% of otherwise taxable income, subject to limitations based on aggregate loans and savings balances. For tax years after 1996, financial institutions meeting the definition of a small bank can use either the “experience method” or the “specific charge-off method” in computing their bad debt deduction. The Company qualifies as a small bank and is using the experience method. As of June 30, 2008, the end of the most recent tax year, the Company’s tax bad debt reserves were approximately $1,312. If these tax bad debt reserves are used for other than loan losses, the amount used will be subject to federal income taxes at the then prevailing corporate rates.

Income taxes are summarized as follows:

	Years Ended June 30,
	2008		2007
Current taxes:
Federal income	$	725	$	604
State excise		186		149
		911		753
Deferred taxes:
Federal income		618		148
State excise		2		7
		620		155
	$	1,531	$	908

F-20

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 10 – INCOME TAXES (CONTINUED)

The provision for income taxes differs from the federal statutory corporate rate as follows:

	Percentage of Earnings Before Income Taxes Years Ended June 30,
	2008		2007
Tax at statutory rate	34.0	%	34.0	%
Increase (decrease) in taxes:
State income taxes, net of federal tax benefit	4.0		3.7
Increase in BOLI cash value	(3.1	)	(3.1	)
Additional ESOP compensation	(2.0	)	(0.5	)
Deferred tax benefit on valuation allowance	24.0		—
Other, net	(1.8	)	0.8
Effective tax rate	55.1	%	34.9	%

The provisions of SFAS No. 109 require the Company to establish a deferred tax liability for the tax effect of the tax bad debt reserves over the base year amounts. There were no excess reserves at June 30, 2008 and 2007. The Company’s base year tax bad debt reserve is $1,312. The estimated deferred tax liability on the base year amount is approximately $502, which has not been recorded in the accompanying consolidated financial statements. The deferred tax asset valuation allowance at June 30, 2008 is related to the expiration of a charitable contribution carryover. The Company has a charitable contribution carryover of $2,306, which expires June 30, 2009. The valuation allowance represents the estimated tax effect portion of the unused contribution carryover that will expire on that date.

F-21

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 10 – INCOME TAXES (CONTINUED)

The components of the net deferred tax asset are summarized as follows:

	June 30,
	2008			2007
Deferred tax liabilities:
FHLB stock dividends	$	(505	)	$	(486	)
Depreciation		(40	)		(64	)
		(545	)		(550	)
Deferred tax assets:
Charitable contributions		784			871
Deferred loan fees, net		104			140
Allowance for “available-for-sale” securities		11			153
MRP compensation		105			108
Stock option expense		144			96
Deferred compensation		39			29
Allowance for losses on loans		708			749
Charge-offs not recognized for tax purposes		161			—
Unearned profit on sale of REO		—			10
Gross deferred tax assets		2,056			2,156
Valuation allowance		(667	)		—
Deferred tax asset		1,389			2,156
Net deferred tax asset	$	844		$	1,606

NOTE 11 – EMPLOYEE BENEFIT PLANS

401 (K) RETIREMENT PLAN. The Company has a defined contribution pension plan covering all employees having attained the age of 20 and ¹/2 and completing six months of service. Normal retirement date is the participant’s sixty-fifth birthday.

Before the Company established the Employee Stock Ownership Plan (effective July 1, 2003), the 401(k) plan was funded by annual employer contributions of 10% of the total plan compensation of all participants in the plan. The amount contributed by the employer was divided among the participants in the same proportion that each participant’s compensation bore to the aggregate compensation of all participants. Employer contributions vest to employees over a seven-year period. Employees are permitted to make contributions of up to 50% of their compensation subject to certain limits based on federal tax laws.

EMPLOYEE STOCK OWNERSHIP PLAN.As part of the conversion, the Bank established an Employee Stock Ownership Plan (ESOP). On July 1, 2003, the ESOP purchased 670,089 shares of Jefferson Bancshares, Inc. from proceeds provided by the Company in the form of a loan. Thus, the ESOP is considered a leveraged plan. Employees are eligible for participation in the plan upon attaining 20 and ¹/2 years of age and completing six consecutive calendar months during which he has performed at least 500 hours of service. Each plan year, the Bank may, in its discretion, make a contribution to the plan; however, at a minimum, the Bank has agreed to make as a contribution the amount necessary to service the debt incurred to acquire the stock.

Shares are scheduled for release as the loan is repaid. The present amortization schedule calls for 43,206.63 shares to be released each December 31. Dividends on unallocated shares are used to repay the loan while dividends paid on allocated shares become part of the plan’s assets. Accounting for the ESOP consists of recognizing compensation expense for the fair market value of the shares as of the date of release. Allocated shares are included in earnings per share calculations while unallocated shares are not included.

F-22

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 11 – EMPLOYEE BENEFIT PLANS (CONTINUED)

ESOP compensation expense was $443 and $551 for the years ended June 30, 2008 and 2007. The original number of shares committed was 670,089 and 43,207 were released during the years ended June 30, 2008 and 2007, respectively. The 475,272 remaining unearned shares had an approximate fair market value of $4,430 at June 30, 2008.

The Bank has also established a SERP to provide for supplemental retirement benefits with respect to the ESOP. The plan provides certain executives with benefits that cannot be provided under the ESOP as a result of the limitations imposed by the Internal Revenue Code, but that would have been provided under the ESOP but for such limitations. The Plan was amended in 2007 to change the first allocation period to December 31, 2007. Compensation expense under the SERP was $15 and $10 for the years ended June 30, 2008 and 2007, respectively.

STOCK COMPENSATION PLANS.The Company maintains stock-based benefit plans under which certain employees and directors are eligible to receive restricted stock grants or options. Under the 2005 Stock-Based Benefit Plan, the maximum number of shares that may be granted as restricted stock is 279,500, and a maximum of 698,750 shares may be issued through the exercise of nonstatutory or incentive stock options. The exercise price of each option equals the market price of the Company’s stock on the date of grant and an option’s maximum term is ten years.

Restricted stock grants aggregating 45,000 shares and having a fair value of $597 were awarded in 2006. Restrictions on the grants lapse in annual increments over five years. The market value as of the grant date of the restricted stock grants is charged to expense as the restrictions lapse. Due to employee departures during the fiscal year, 12,800 shares were forfeited. Compensation expense for grants vesting in 2008 and 2007 was $523 and $551, respectively.

A summary of the status of the Company’s stock option plan is presented below:

	2008					2007
	Shares			Weighted Average Exercise Price		Shares			Weighted Average Exercise Price
Outstanding at beginning of year		401,778		$	13.69		441,504		$	12.82
Granted		—			—		—			—
Exercised		—			—		(39,726	)		4.02
Forfeited		(1,746	)				—
Outstanding at end of year		400,032			13.69		401,778			13.69
Options exercisable at year-end		321,434			13.69		241,083			13.69
Weighted-average fair value of options granted during the year	$	—				$	—

F-23

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 11 – EMPLOYEE BENEFIT PLANS (CONTINUED)

Information pertaining to options outstanding at June 30, 2008 is as follows:

	Options Outstanding				Options Exercisable
Exercise Price	Number Outstanding	Weighted Average Remaining Contractual Life	Weighted Average Exercise Price		Number Exercisable	Weighted Average Exercise Price
$13.69	400,032	5.58 years	$	13.69	321,434	$	13.69

NOTE 12 – MINIMUM REGULATORY CAPITAL REQUIREMENTS

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company and 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 its assets, liabilities and certain off-balance-sheet items as calculated under regulatory accounting practices. The capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.

Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined) and core and tangible capital (as defined) to tangible assets (as defined). Management believes as of June 30, 2008 and 2007, that the Bank met all capital adequacy requirements to which it was subject.

As of June 30, 2008, the most recent notification from the Office of Thrift Supervision categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized, an institution must maintain minimum total risk-based, Tier 1 risk-based and Tier 1 leverage ratios as set forth in the following tables. There are no conditions or events since the notification that management believes have changed the Bank’s category. The Bank’s actual capital amounts and ratios as of June 30, 2008 and 2007 are also presented in the table.

F-24

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 12 – MINIMUM REGULATORY CAPITAL REQUIREMENTS (CONTINUED)

	Actual				Minimum Capital Requirements					Minimum To Be Well Capitalized Under Prompt Corrective Action Provisions
	Amount		Ratio		Amount		Ratio			Amount		Ratio
As of June 30, 2008:
Total Capital (to Risk Weighted Assets)	$	66,271	24.2	%	$	21,941	³	8.0	%	$	27,426	³	10.0	%
Core Capital (to Tangible Assets)		64,472	19.6	%		13,175	³	4.0	%		16,469	³	5.0	%
Tangible Capital (to Tangible Assets)		64,472	19.6	%		4,941	³	1.5	%		N/A
Tier 1 Capital (to Risk Weighted Assets)		64,472	23.5	%		N/A					16,455	³	6.0	%
As of June 30, 2007:
Total Capital (to Risk Weighted Assets)	$	67,123	25.5	%	$	21,099	³	8.0	%	$	26,374	³	10.0	%
Core Capital (to Tangible Assets)		65,205	19.3	%		13,496	³	4.0	%		16,870	³	5.0	%
Tangible Capital (to Tangible Assets)		65,205	19.3	%		5,061	³	1.5	%		N/A
Tier 1 Capital (to Risk Weighted Assets)		65,205	24.7	%		N/A					15,824	³	6.0	%

The following table provides reconciliation between GAAP capital and the various categories of regulatory capital:

	Bank June 30,
	2008			2007
GAAP Capital	$	65,182		$	65,699
Adjustments:
Deferred taxes		(727	)		(726	)
Unrealized (gains)/losses		17			232
Core, Tangible and Tier 1 Capital		64,472			65,205
Adjustments:
Allowances for losses		1,799			1,918
Total Capital	$	66,271		$	67,123

F-25

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 13 – RESTRICTIONS ON DIVIDENDS, LOANS AND ADVANCES

Federal and state banking regulations place certain restrictions on dividends paid and loans or advances made by the Bank to the Company. The total amount of dividends which may be paid at any date is generally limited to the retained earnings of the Bank, and loans or advances are limited to 10 percent of the Bank’s capital stock and surplus on a secured basis.

At June 30, 2008, the Bank’s retained earnings available for the payment of dividends was $29,445. Accordingly, $40,981 of the Company’s equity in the net assets of the Bank was restricted at June 30, 2008. Funds available for loans or advances by the Bank to the Company amounted to $6,518.

In addition, dividends paid by the Bank to the Company would be prohibited if the effect thereof would cause the Bank’s capital to be reduced below applicable minimum capital requirements.

NOTE 14 – FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK

The Company is a party to financial instruments with off-balance sheet risk in the normal course of business. These financial instruments generally include commitments to originate mortgage loans. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized on the balance sheet. The Company’s maximum exposure to credit loss in the event of nonperformance by the borrower is represented by the contractual amount and related accrued interest receivable of those instruments. The Company minimizes this risk by evaluating each borrower’s creditworthiness on a case-by-case basis. Collateral held by the Company consists of a first or second mortgage on the borrower’s property. The amount of collateral obtained is based upon an appraisal of the property.

The fair value of a financial instrument is the current amount that would be exchanged between willing parties, other than in a forced liquidation. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company’s various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument. SFAS 107 excludes certain financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

F-26

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 14 – FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK (CONTINUED)

The estimated fair values of the Company’s financial instruments are as follows:

	June 30, 2008						June 30, 2007
	Carrying Amount			Fair Value			Carrying Amount			Fair Value
Financial assets:
Cash and balances due from banks and interest-bearing deposits with banks	$	17,616		$	17,616		$	7,734		$	7,734
Available-for-sale and held-to maturity securities		3,478			3,478			27,278			27,278
Federal Home Loan Bank stock		1,868			1,868			1,796			1,796
Loans receivable		282,483			282,720			274,881			269,949
Accrued interest receivable		1,246			1,246			1,713			1,713
Loans held-for-sale		258			258			2,468			2,468
Financial liabilities:
Deposits		(223,552	)		(223,886	)		(220,082	)		(220,774	)
FHLB Advance		(33,000	)		(33,552	)		(44,800	)		(44,628	)
Off-balance-sheet credit items:
Commitments to extend credit		—			1,775			—			1,260
Letters of credit		—			8,033			—			10,185
Unused lines of credit		—			20,000			—			15,355

NOTE 15 – COMMITMENTS AND CONTINGENCIES

Commitments to originate mortgage loans are legally binding agreements to lend to the Company’s customers and generally expire in ninety days or less. Commitments at June 30, 2008 to originate adjustable-rate loans were approximately $1.1 million. Commitments at June 30, 2008 to originate fixed-rate loans were approximately $514 with a term of twenty years or less and interest rates of 6.50% to 7.25%. Commitments at June 30, 2007 to originate adjustable-rate loans were approximately $663. Commitments at June 30, 2007 to originate fixed-rate loans with terms of fifteen years or less were approximately $597. Fixed rates ranged from 7.40% to 8.40% for June 30, 2007.

The Company has entered into an employment agreement with its President and CEO Anderson L. Smith. Agreement stipulations are terms, duties, compensation and performance bonuses and provides remedies for both parties upon certain events occurring. Mr. Smith’s agreement provides for deferred compensation upon him attaining age 65.

Upon completion of the conversion, a “liquidation account” was established in an amount equal to the total equity of the Bank as of the latest practicable date prior to the conversion. The liquidation account was established to provide limited priority claim to the assets of the Bank to “eligible account holders”, as defined in the Plan of Conversion, who continue to maintain deposits in the Bank after the conversion. In the unlikely event of a complete liquidation of the Bank, and only in such event, each eligible account holder and supplemental eligible account holder would receive a liquidation distribution, prior to any payment to the holder of the Bank’s common stock. This distribution would be based upon each eligible account holder’s and supplemental eligible account holder’s proportionate share of the then total remaining qualifying deposits. At the time of the conversion, the liquidation account, which is an off-balance sheet memorandum account, amounted to $29.5 million.

F-27

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 16 – RELATED PARTY TRANSACTIONS

In the ordinary course of business, the Company obtains products and services from directors or affiliates thereof. In the opinion of management, such transactions are made on substantially the same terms as those prevailing at the time for comparable transactions with unaffiliated persons.

NOTE 17 – CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY

Financial information pertaining only to Jefferson Bancshares, Inc. is as follows:

	June 30, 2008
Balance Sheet
Assets
Cash and due from banks	$	1,595
Investment securities classified as available for sale, net		—
Investment in common stock of Jefferson Federal Bank		71,426
Loan receivable from ESOP		5,150
Deferred tax asset		117
Other assets		218
Total assets	$	78,506
Liabilities and Stockholders’ Equity
Accrued expenses	$	486
Stockholders’ equity		78,020
Total liabilities and stockholders’ equity	$	78,506
	Year Ended June 30, 2008
Statement of Income
Dividends from Jefferson Federal Bank	$	4,000
Interest on investment securities		23
Other income		240
Total income		4,263
Other operating expenses		304
Income before income taxes and equity in undistributed net income of Jefferson Federal Bank		3,959
Income tax		661
		3,298
Equity in undistributed net income of Jefferson Federal Bank		(2,051	)
Net income	$	1,247

F-28

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 17 – CONDENSED FINANCIAL STATEMENTS OF PARENT COMPANY (CONTINUED)

	Year Ended June 30, 2008
Statement of Cash Flows
Cash flows from operating activities:
Net income	$	1,247
Adjustments to reconcile net income to net cash provided by operating activities:
Dividends in excess of net income of Jefferson Federal Bank		2,051
Deferred tax expense		755
Decrease in other assets		(1,002	)
Decrease in other liabilities		70
Net cash provided by operations		3,121
Cash flows from investing activities:
Sales and maturities of debt securities		1,000
Investment in Jefferson Federal Bank		(20	)
Return of principal on loan to ESOP		368
Net cash provided by investing activities		1,348
Cash flows from financing activities:
Purchase of treasury stock		(2,155	)
Dividends paid on common stock		(1,520	)
Dividends on unallocated MRP shares received by MRP and used to pay MRP and ESOP administrative expenses		20
Net cash used for financing activities		(3,655	)
Net increase in cash and cash equivalents		814
Cash and cash equivalents at beginning of year		781
Cash and cash equivalents at end of year	$	1,595

F-29

JEFFERSON BANCSHARES, INC. AND SUBSIDIARY

Notes to Consolidated Financial Statements

(Dollars in Thousands)

NOTE 18 – QUARTERLY FINANCIAL INFORMATION

The following table summarizes selected information regarding the Company’s results of operations for the periods indicated (in thousands except per share data):

	Three Months Ended
	September 30, 2007		December 31, 2007			March 31, 2008		June 30, 2008
	(Unaudited)
Interest income	$	5,411	$	5,491		$	5,198	$	4,746
Interest expense		2,510		2,535			2,293		1,910
Net interest income		2,901		2,956			2,905		2,836
Provision for loan losses		68		60			243		80
Net interest income after reduction in provision for loan losses		2,833		2,896			2,662		2,756
Noninterest income		412		347			378		383
Noninterest expense		2,569		2,538			2,290		2,492
Earnings before income taxes		676		705			750		647
Income taxes		242		881			255		153
Net earnings (loss)	$	434	$	(176	)	$	495	$	494
Earnings per share, basic	$	0.07	$	(0.03	)	$	0.09	$	0.09
Earnings per share, diluted	$	0.07	$	(0.03	)	$	0.09	$	0.09
	Three Months Ended
	September 30, 2006		December 31, 2006			March 31, 2007		June 30, 2007
	(Unaudited)
Interest income	$	5,134	$	5,236		$	5,217	$	5,417
Interest expense		2,385		2,428			2,381		2,466
Net interest income		2,749		2,808			2,836		2,951
Provision for loan losses		—		30			—		—
Net interest income after provision for loan losses		2,749		2,778			2,836		2,951
Noninterest income		387		310			324		334
Noninterest expense		2,666		2,539			2,449		2,416
Earnings before income taxes		470		549			711		869
Income taxes		180		200			257		271
Net earnings	$	290	$	349		$	454	$	598
Earnings per share, basic	$	0.05	$	0.06		$	0.07	$	0.10
Earnings per share, diluted	$	0.05	$	0.06		$	0.07	$	0.10

F-30