First Financial Service (FFKY) 10-Q 2013 Q3 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended September 30, 2013

OR

¨           TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

Commission File Number 0-18832

First Financial Service Corporation

(Exact Name of Registrant as specified in its charter)

Kentucky	61-1168311
(State or other jurisdiction	(IRS Employer Identification No.)
of incorporation or organization)

2323 Ring Road	(270) 765-2131
Elizabethtown, Kentucky 42701	(Registrant's telephone number,
(Address of principal executive offices)	including area code)
(Zip Code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. 

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

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

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Class	Outstanding as of October 31, 2013
Common Stock	4,862,023 shares

FIRST FINANCIAL SERVICE CORPORATION

FORM 10-Q

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION
Preliminary Note Regarding Forward-Looking Statements
Item 1.	Consolidated Financial Statements and Notes to Consolidated Financial Statements (Unaudited)	4
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	37
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	55
Item 4.	Controls and Procedures	57
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	57
Item 1A.	Risk Factors	58
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	58
Item 3.	Defaults upon Senior Securities	58
Item 4.	Mine Safety Disclosures	58
Item 5.	Other Information	58
Item 6.	Exhibits	58
SIGNATURES		59

2

PRELIMINARY NOTE REGARDING

FORWARD-LOOKING STATEMENTS

Statements in this report that are not statements of historical fact are forward-looking statements. First Financial Service Corporation (the “Corporation”) may make forward-looking statements in future filings with the Securities and Exchange Commission (“SEC”), in press releases, and in oral and written statements made by or with the approval of the Corporation. Forward-looking statements include, but are not limited to: (1) projections of revenues, income or loss, earnings or loss per share, capital structure and other financial items; (2) plans and objectives of the Corporation or its management or Board of Directors; (3) statements regarding future events, actions or economic performance; and (4) statements of assumptions underlying such statements. Words such as “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar expressions are intended to identify forward-looking statements, but are not the exclusive means of identifying such statements.

Various risks and uncertainties may cause actual results to differ materially from those indicated by our forward-looking statements. In addition to those risks described under “Item 1A Risk Factors,” of both this report and our Annual Report on Form 10-K, the following factors could cause such differences: our ability to increase our capital to the levels required by our agreements with bank regulators; the significant amount of OREO properties we hold, which could increase operating expenses and result in future losses; the accuracy of our decisions regarding credit risk; the adequacy of our allowance for loan losses to cover actual credit losses; changes in general economic conditions and economic conditions in Kentucky and the markets we serve, any of which may affect, among other things, our level of non-performing assets, charge-offs, and provision for loan loss expense; changes in interest rates that may reduce interest margins and impact funding sources; changes in market rates and prices which may adversely impact the value of financial products including securities, loans and deposits; changes in tax laws, rules and regulations; various monetary and fiscal policies and regulations, including those adopted by the Federal Reserve Board, the Federal Deposit Insurance Corporation (“FDIC”) or the Kentucky Department of Financial Institutions (“KDFI”); competition with other local and regional commercial banks, savings banks, credit unions and other non-bank financial institutions; our ability to grow core businesses; our ability to develop and introduce new banking-related products, services and enhancements and gain market acceptance of such products; and management’s ability to manage these and other risks. 

Our forward-looking statements speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statement to reflect events or circumstances occurring after the date of any such statement.

3

Item 1. FIRST FINANCIAL SERVICE CORPORATION

Consolidated Balance Sheets

(Unaudited)

	September 30,		December 31,
(Dollars in thousands, except per share data)	2013		2012
ASSETS:
Cash and due from banks	$	13,441	$	12,598
Interest bearing deposits		18,076		50,505
Total cash and cash equivalents		31,517		63,103
Securities available-for-sale		290,183		354,131
Loans held for sale		1,068		3,887
Loans, net of unearned fees		476,031		524,835
Allowance for loan losses		(12,224)		(17,265)
Net loans		463,807		507,570
Federal Home Loan Bank stock		4,430		4,805
Cash surrender value of life insurance		10,336		10,060
Premises and equipment, net		25,907		27,048
Real estate owned:
Acquired through foreclosure, net of valuation     allowance of $721 Sept (2013) and $500 Dec (2012)		8,859		22,286
Other repossessed assets		16		34
Accrued interest receivable		2,283		2,690
Accrued income taxes		2,907		2,928
Low-income housing investments		7,039		7,061
Other assets		1,804		1,459
TOTAL ASSETS	$	850,156	$	1,007,062
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Deposits:
Non-interest bearing	$	80,308	$	75,842
Interest bearing		666,570		846,778
Total deposits		746,878		922,620
Advances from Federal Home Loan Bank		38,424		12,596
Subordinated debentures		18,000		18,000
Accrued interest payable		4,137		3,121
Accrued senior preferred dividend		3,219		2,469
Accounts payable and other liabilities		4,977		3,884
TOTAL LIABILITIES		815,635		962,690
Commitments and contingent liabilities
STOCKHOLDERS' EQUITY:
Senior preferred stock, $1 par value per share;     authorized 5,000,000 shares; issued and     outstanding, 20,000 shares with a liquidation     preference of $23.2 million Sept (2013), and     $22.5 million Dec (2012)		19,984		19,943
Common stock, $1 par value per share;     authorized 35,000,000 shares; issued and     outstanding, 4,861,523 shares Sept (2013), and 4,775,114     shares Dec (2012)		4,861		4,775
Additional paid-in capital		36,137		35,782
Accumulated deficit		(17,726)		(17,398)
Accumulated other comprehensive income		(8,735)		1,270
TOTAL STOCKHOLDERS' EQUITY		34,521		44,372
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$	850,156	$	1,007,062

See notes to the unuaudited consolidated financial statements.            

4

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Operations

(Unaudited)

	Three Months Ended				Nine Months Ended
(Amounts in thousands, except per share data)	September 30,				September 30,
	2013		2012		2013		2012
Interest and Dividend Income:
Loans, including fees	$	6,308	$	8,082	$	19,729	$	26,911
Taxable securities		1,700		1,666		4,898		5,303
Tax exempt securities		53		74		185		230
Total interest income		8,061		9,822		24,812		32,444
Interest Expense:
Deposits		1,561		2,952		5,471		10,341
Federal Home Loan Bank advances		133		216		397		783
Subordinated debentures		340		421		1,022		1,103
Total interest expense		2,034		3,589		6,890		12,227
Net interest income		6,027		6,233		17,922		20,217
Provision for loan losses		(500)		2,671		(1,325)		4,598
Net interest income after provision for loan losses		6,527		3,562		19,247		15,619
Non-interest Income:
Customer service fees on deposit accounts		1,444		1,339		3,942		4,121
Gain on sale of mortgage loans		230		505		818		1,200
Gain on sale of investments		235		2,054		1,078		3,363
Loss on sale of investments		(223)		(350)		(839)		(653)
Other than temporary impairment loss:
Total other-than-temporary impairment losses		-		-		-		(26)
Portion of loss recognized in other     comprehensive income/(loss) (before taxes)		-		-		-		-
Net impairment losses recognized in earnings		-		-		-		(26)
Loss on sale and write downs on real estate     acquired through foreclosure		(365)		(1,587)		(1,957)		(5,169)
Gain on branch divesture		-		3,124		-		3,124
Gain on sale of premises and equipment		-		-		-		322
Gain on sale on real estate acquired through foreclosure		1,632		630		1,839		1,243
Gain on sale of real estate held for development		-		-		-		175
Brokerage commissions		127		109		384		316
Other income		466		632		1,421		1,660
Total non-interest income		3,546		6,456		6,686		9,676
Non-interest Expense:
Employee compensation and benefits		3,955		3,609		11,505		11,284
Office occupancy expense and equipment		653		777		2,051		2,327
Marketing and advertising		99		113		273		281
Outside services and data processing		900		853		2,704		2,557
Bank franchise tax		315		402		708		1,146
FDIC insurance premiums		460		663		1,654		1,760
Amortization of intangible assets		-		-		-		127
Real estate acquired through foreclosure expense		452		638		1,270		3,314
Loan expense		485		568		1,092		1,732
FHLB advance perpayment penalty		-		1,548		-		1,548
Other expense		1,286		1,682		4,211		4,482
Total non-interest expense		8,605		10,853		25,468		30,558
Income (Loss) before income taxes		1,468		(835)		465		(5,263)
Income tax expense/(benefit)		1		(84)		2		(83)
Net Income (Loss)		1,467		(751)		463		(5,180)
Less:
Dividends on preferred stock		(250)		(250)		(750)		(750)
Accretion on preferred stock		(14)		(14)		(41)		(41)
Net income (loss) attributable to common shareholders	$	1,203	$	(1,015)	$	(328)	$	(5,971)
Shares applicable to basic income (loss) per common share		4,860,115		4,772,987		4,816,538		4,766,898
Basic income (loss) per common share	$	0.25	$	(0.21)	$	(0.07)	$	(1.25)
Shares applicable to diluted income (loss) per common share		4,905,542		4,772,987		4,816,538		4,766,898
Diluted income (loss) per common share	$	0.25	$	(0.21)	$	(0.07)	$	(1.25)
Cash dividends declared per common share	$	-	$	-	$	-	$	-

See notes to the unuaudited consolidated financial statements.

5

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Comprehensive Income/(Loss)

(Unaudited)

	Three Months Ended				Nine Months Ended
(Dollars in thousands)	September 30,				September 30,
	2013		2012		2013		2012
Net Income (Loss)	$	1,467	$	(751)	$	463	$	(5,180)
Other comprehensive income (loss):
Change in unrealized gain (loss)     on securities available-for-sale		(1,438)		2,212		(9,766)		2,980
Change in unrealized gain (loss)     on securities available-for-sale     for which a portion of other-than-temporary     impairment has been recognized into earnings		-		98		-		77
Reclassification of realized amount on     securities available-for-sale losses (gains)		(12)		(1,704)		(239)		(2,710)
Reclassification of unrealized loss on     held-to-maturity security recognized in income		-		-		-		26
Accretion (amortization) of non-credit component     of other-than-temporary impairment     on held-to-maturity securities		-		-		-		50
Net unrealized gain (loss) recognized in     comprehensive income		(1,450)		606		(10,005)		423
Tax effect		-		(206)		-		(206)
Total other comphrehensive income (loss)		(1,450)		400		(10,005)		217
Comprehensive Income (Loss)	$	17	$	(351)	$	(9,542)	$	(4,963)

See notes to the unaudited consolidated financial statements.

6

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Changes in Stockholders' Equity

Nine Months Ended September 30, 2013

(Dollars In Thousands, Except Per Share Amounts)

(Unaudited)

	Shares				Amount				Additional Paid-in		Accumulated			Accumulated Other Comprehensive Income, Net of
	Preferred		Common		Preferred		Common		Capital		Deficit			Tax		Total
Balance, January 1, 2013		20,000		4,775,114	$	19,943	$	4,775	$	35,782		$	(17,398)	$	1,270	$	44,372
Net income		-		-		-		-		-			463		-		463
Stock issued for stock options
exercised and employee benefit plans		-		20,481		-		20		28			-		-		48
Issuance of restricted shares		-		65,928		-		66		(66)			-		-		-
Stock-based compensation expense		-		-		-		-		393			-		-		393
Total other comprehensive income (loss)		-		-		-		-		-			-		(10,005)		(10,005)
Dividends on preferred stock		-		-		-		-		-			(750)		-		(750)
Accretion of preferred stock discount		-		-		41		-		-			(41)		-		-
Balance, September 30, 2013		20,000		4,861,523	$	19,984	$	4,861	$	36,137		$	(17,726)	$	(8,735)	$	34,521

See notes to the unaudited consolidated financial statements.

7

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Cash Flows

(Dollars In Thousands)

(Unaudited)

	Nine Months Ended
	September 30,
	2013		2012
Operating Activities:
Net loss	$	463	$	(5,180)
Adjustments to reconcile net income/(loss) to net cash provided     by operating activities:
Provision for loan losses		(1,325)		4,598
Depreciation on premises and equipment		1,086		1,146
Change in real estate acquired through foreclosure valuation allowance		221		-
Intangible asset amortization		-		127
Loss on low-income housing investments		46		275
Net amortization (accretion) available-for-sale		5,394		(4,764)
Impairment loss on securities held-to-maturity		-		26
Gain on sale of investments available-for-sale		(1,078)		(3,171)
Gain on call of investments held-to-maturity		-		(192)
Loss on sale of investments available-for-sale		839		653
Gain on sale of mortgage loans		(818)		(1,200)
Gain on branch divesture		-		(3,124)
Gain on sale of premises and equipment		-		(322)
Loss on sale of premises and equipment		70		-
Gain on sale of real estate acquired through foreclosure		(1,839)		(1,243)
Loss on sale of real estate acquired through foreclosure		372		256
Gain on sale of real estate held for development		-		(175)
Write-downs on real estate acquired through foreclosure		1,585		4,913
Origination of loans held for sale		(46,807)		(47,294)
Proceeds on sale of loans held for sale		50,444		55,975
Stock-based compensation expense		393		202
Prepaid FDIC premium		-		1,302
Changes in:
Cash surrender value of life insurance		(276)		(269)
Interest receivable		407		650
Other assets		(345)		1,388
Interest payable		1,016		966
Accrued income tax		21		-
Accounts payable and other liabilities		1,093		1,692
Net cash from operating activities		10,962		7,235
Investing Activities:
Cash paid for the disposition of branches		-		(80,248)
Sales of securities available-for-sale		125,351		214,830
Call of securities held-to-maturity		-		208
Purchases of securities available-for-sale		(108,926)		(274,567)
Maturities of securities available-for-sale		32,363		59,436
Maturities of securities held-to-maturity		-		58
Net change in loans		42,844		104,152
Sale of portfolio loans		-		10,693
Redemption of Federal Home Loan Bank stock		375		-
Investment in low-income housing projects		(24)		(24)
Net purchases of premises and equipment		(537)		(202)
Sales of premises and equipment		522		1,575
Proceeds from sales of real estate acquired through foreclosure		15,350		10,979
Sales of real estate held for development		-		220
Net cash from investing activities		107,318		47,110
Financing Activities
Net change in deposits		(175,742)		(76,182)
Advance from Federal Home Loan Bank		26,000		-
Repayments to Federal Home Loan Bank		(172)		(15,105)
Issuance of common stock under dividend reinvestment program		-		5
Issuance of common stock for employee benefit plans and exercise     of stock options		48		38
Net cash from financing activities		(149,866)		(91,244)
Increase (decrease) in cash and cash equivalents		(31,586)		(36,899)
Cash and cash equivalents, beginning of period		63,103		92,236
Cash and cash equivalents, end of period	$	31,517	$	55,337
Supplemental noncash disclosures:
Transfers from loans to real estate acquired through     foreclosure and repossessed assets	$	2,369	$	15,682
Loans to facilitate sales of real estate owned and     repossessed assets	$	125	$	243
Dividends accrued not paid on preferred stock	$	750	$	750
Transfers from loans to loans held for sale in probable     branch divestiture	$	-	$	11,304

See notes to the unaudited consolidated financial statements.

8

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES  

Basis of Presentation – The accompanying unaudited consolidated financial statements include the accounts of First Financial Service Corporation (the “Corporation”) and its wholly owned subsidiary, First Federal Savings Bank (the “Bank”). First Federal Savings Bank has three wholly owned subsidiaries, First Service Corporation of Elizabethtown, Heritage Properties, LLC and First Federal Office Park, LLC. Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its wholly owned subsidiary, collectively referred to as the “Company”. All significant intercompany transactions and balances have been eliminated in consolidation.

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and nine month periods ending September 30, 2013 are not necessarily indicative of the results that may occur for the year ending December 31, 2013. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2012.

Reclassifications – Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year operations or shareholder’s equity.

Adoption of New Accounting Standards – Effective February 2013, we adopted, ASU No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive (ASU 2013-02). This guidance is the culmination of the FASB’s deliberation on reporting reclassification adjustments from accumulated other comprehensive income (AOCI). The amendments in ASU 2013-02 do not change the current requirements for reporting net income or other comprehensive income. However, the amendments require disclosure of amounts reclassified out of AOCI in its entirety, by component, on the face of the statement of operations or in the notes thereto. Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail.  This standard was effective for public entities for annual and interim reporting periods beginning after December 15, 2012. The adoption of this update did not have a material impact on the consolidated financial statements.

In July 2013, the Financial Accounting Standards Board issued Accounting Standards Update 2013-11, Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists (ASU 2013-11). Current GAAP does not include explicit guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss carryforward, a similar tax loss, or a tax credit carryforward exists. The adoption of ASU 2013-11 will require an unrecognized tax benefit, or a portion of an unrecognized tax benefit to be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward, unless an exception applies. The amendments in this update are effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2013. We are currently evaluating the effect that the provisions of ASU 2013-11 will have on the consolidated financial statements.

9

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

2. REGULATORY MATTERS

Since January 2011, the Bank has operated under Consent Orders with the Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of Financial Institutions (“KDFI”). The initial Consent Order required the Bank to achieve a total capital to risk-weighted assets ratio of 12% and a Tier 1 capital to average total assets ratio of 9%. It also prohibited the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and has required the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. When the Bank entered into a new Consent Order with the FDIC and KDFI in March 2012, it agreed that should it be unable to reach the required capital levels by June 30, 2012, and if directed in writing by the FDIC, then within 30 days the Bank would develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution. To date, the Bank has not received such a written direction. The latest Consent Order also includes the same substantive provisions as the initial Consent Order and requires the Bank to continue to adhere to the plans implemented in response to the initial Consent Order.

Copies of the Consent Orders are included as exhibits to our Form 8–K filed on January 27, 2011 and our 2011 Annual Report on Form 10-K filed March 30, 2012.

In April 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order. We also may not redeem shares or obtain additional borrowings without prior approval.

At September 30, 2013, the Bank’s Tier 1 capital ratio was 7.80% and the total risk-based capital ratio was 13.09% compared to the minimum 9.00% and 12.00% capital ratios required by the Consent Order. For the fourth consecutive quarter, we have achieved and maintained the total risk-based capital ratio but have yet to achieve the Tier 1 capital ratio. We are continuing to explore our strategic alternatives to achieve and maintain the Tier 1 capital ratio as well as to comply with all of the other terms of the consent order.

The Bank is currently designated as a "troubled institution” which status prohibits the Bank from accepting, renewing or rolling over brokered deposits and restricts the amount of interest the Bank may pay on deposits. 

Bank regulatory agencies have discretion when an institution does not meet the terms of a regulatory order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any material failures to comply with our regulatory orders would likely result in more stringent enforcement actions by the bank regulatory agencies, which could damage our reputation and have a material adverse effect on our business.

The Consent Order and the formal agreement will remain in effect until modified or terminated by the FDIC, KDFI and Federal Reserve Bank of St. Louis.

Management and the Board of Directors have been actively engaged with our investment banking firm in reviewing all of the strategic alternatives. One of these alternatives was to sell branches that were located outside of our core market. On July 6, 2012, we sold our four banking centers in Southern Indiana, receiving a 3.65% premium on the $102.3 million of consumer and commercial deposits at closing. The buyer assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received no premium or discount. We also sold approximately $30.4 million in performing loans at a discount of 0.80%. Other assets sold included vault cash of $367,000 and fixed assets of $887,000. The Indiana branch sale resulted in a gain of $3.1 million.

10

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

2. REGULATORY MATTERS – (Continued)

Our plans for the remainder of 2013 include the following:

· Continuing to identify and evaluate available strategic options to meet regulatory capital levels and all other requirements of our Consent Order.

· Continuing to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise.

· Continuing to reduce expenses and improve our ability to operate in a profitable manner.

· Continuing to reduce our lending concentration in commercial real estate through expected maturities and repayments.

· Enhancing our resources dedicated to special asset dispositions, both on a permanent and temporary basis, to accelerate our efforts to dispose of problem assets.

· Continuing to reduce our inventory of other real estate owned properties.

11

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3. SECURITIES

The amortized cost basis and fair values of securities are as follows:

			Gross		Gross
(Dollars in thousands)	Amortized		Unrealized		Unrealized
	Cost		Gains		Losses		Fair Value
Securities available-for-sale:
September 30, 2013:
Government-sponsored     mortgage-backed residential	$	119,475	$	35	$	(4,960)	$	114,550
Government-sponsored     collateralized mortgage obligations		78,732		300		(1,290)		77,742
Asset backed-collateralized loan obligations		33,102		-		(446)		32,656
State and municipal		12,257		423		(14)		12,666
Corporate bonds		52,794		222		(447)		52,569
Total	$	296,360	$	980	$	(7,157)	$	290,183
December 31, 2012:
U.S. Treasury and agencies	$	8,284	$	7	$	(13)	$	8,278
Government-sponsored     mortgage-backed residential		144,617		774		(502)		144,889
Government-sponsored     collateralized mortgage obligations		148,460		2,033		(346)		150,147
Private asset backed		4,981		151		-		5,132
State and municipal		11,394		1,324		-		12,718
Corporate bonds		32,567		433		(33)		32,967
Total	$	350,303	$	4,722	$	(894)	$	354,131

The amortized cost and fair value of securities at September 30, 2013, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.

	Available for Sale
	Amortized		Fair
(Dollars in thousands)	Cost		Value
Due in one year or less	$	3,064	$	3,068
Due after one year through five years		49,485		49,406
Due after five years through ten years		4,751		4,624
Due after ten years		7,751		8,137
Investment securities with no single     maturity date:
Government-sponsored mortgage-backed     residential		119,475		114,550
Government-sponsored collateralized     mortgage obligations		78,732		77,742
Asset backed-collateralized loan     obligations		33,102		32,656
	$	296,360	$	290,183

12

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3. SECURITIES – (Continued)

The following schedule shows the proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
(Dollars in thousands)
Proceeds from sales	$	24,295	$	127,569	$	125,351	$	214,830
Gross realized gains		235		2,054		1,078		3,363
Gross realized losses		223		350		839		653

Investment securities pledged to secure public deposits and Federal Home Loan Bank (FHLB) advances had an amortized cost of $145.3 million and fair value of $142.6 million at September 30, 2013 and a $130.4 million amortized cost and fair value of $132.3 million at December 31, 2012.

Securities with unrealized losses at September 30, 2013 and December 31, 2012 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:

September 30, 2013	Less than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
Description of Securities	Value		Loss		Value		Loss		Value		Loss
Government-sponsored     mortgage-backed residential	$	103,205	$	(4,608)	$	8,658	$	(352)	$	111,863	$	(4,960)
Government-sponsored collateralized     mortgage obligations		40,463		(1,013)		6,739		(277)		47,202		(1,290)
Asset backed-collateralized loan obligations		32,656		(446)		-		-		32,656		(446)
State and municipal		3,614		(14)		-		-		3,614		(14)
Corporate bonds		24,769		(447)		-		-		24,769		(447)
Total temporarily impaired	$	204,707	$	(6,528)	$	15,397	$	(629)	$	220,104	$	(7,157)

December 31, 2012	Less than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
Description of Securities	Value		Loss		Value		Loss		Value		Loss
U.S. Treasury and agencies	$	3,255	$	(13)	$	-	$	-	$	3,255	$	(13)
Government-sponsored     mortgage-backed residential		82,137		(502)		-		-		82,137		(502)
Government-sponsored collateralized     mortgage obligations		33,275		(346)		-		-		33,275		(346)
Corporate bonds		5,731		(33)		-		-		5,731		(33)
Total temporarily impaired	$	124,398	$	(894)	$	-	$	-	$	124,398	$	(894)

We evaluate investment securities with significant declines in fair value on at least a quarterly basis, and more frequently when economic or market concerns warrant such evaluation, to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary.

In conducting this assessment, the Bank evaluates a number of factors including, but not limited to:

·     The length of time and the extent to which fair value has been less than the amortized cost basis;

·     The Bank’s intent to hold until maturity or sell the debt security prior to maturity;

·     An analysis of whether it is more likely than not that the Bank will be required to sell the debt security before its anticipated recovery;

·    Adverse conditions specifically related to the security, an industry, or a geographic area;

13

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3. SECURITIES – (Continued)

·     The historical and implied volatility of the fair value of the security;

·     The payment structure of the security and the likelihood of the issuer being able to make payments;

·     Failure of the issuer to make scheduled interest or principal payments;

·     Any rating changes by a rating agency; and

·     Recoveries or additional decline in fair value subsequent to the balance sheet date.

Accounting guidance requires entities to split other than temporary impairment charges between credit losses (i.e., the loss based on the entity’s estimate of the decrease in cash flows, including those that result from expected voluntary prepayments), which are charged to earnings, and the remainder of the impairment charge (non-credit component) to accumulated other comprehensive income. This requirement pertains to both debt securities held to maturity and debt securities available for sale.

The unrealized losses on our investment securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities. Mortgage backed securities held in our investment portfolio were issued by U.S. government-sponsored entities and agencies, primarily Freddie Mac (“FHLMC”) and Fannie Mae (“FNMA”), institutions that the government has affirmed its commitment to support. Because the decline in market value on our investment securities is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at September 30, 2013.

We recognized other-than-temporary impairment charges of $26,000 for the expected credit loss during the 2012 period. The 2012 impairment charge was related to Preferred Term Security VI which was called for early redemption in July 2012.

The table below presents a roll-forward of the credit losses recognized in earnings. During 2012, all of our trust preferred securities were either called or sold which represented the remaining balance in the OTTI roll-forward.

(Dollars in thousands)	Three Months Ended		Nine Months Ended
	September 30,		September 30,
		2012		2012
Beginning balance	$	2,104	$	2,078
Increases to the amount related to the credit loss for which     other-than-temporary impairment was previously recognized		-		26
Sales/call of securities		(628)		(628)
Ending balance	$	1,476	$	1,476

14

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS

Loans are summarized as follows:

	September 30,		December 31,
(Dollars in thousands)	2013		2012
Commercial Real Estate (CRE):
Other-CRE other than Land
Development and Building Lots	$	263,509	$	290,424
Land Development		22,395		28,310
Building Lots		1,599		2,151
Residential mortgage		101,281		110,025
Consumer and home equity		53,988		57,888
Commercial		20,394		19,931
Indirect consumer		12,938		16,211
		476,104		524,940
Less:
Net deferred loan origination fees		(73)		(105)
Allowance for loan losses		(12,224)		(17,265)
		(12,297)		(17,370)
Net Loans	$	463,807	$	507,570

The following tables present the activity in the allowance for loan losses by portfolio segment for the quarter and nine months ending September 30, 2013 and 2012:

Three Months Ended
September 30, 2013			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	908	$	14,054	$	375	$	396	$	214	$	15,947
Provision for loan losses		177		(790)		49		67		(3)		(500)
Charge-offs		(48)		(3,076)		(73)		(111)		(45)		(3,353)
Recoveries		10		63		13		8		36		130
Total ending allowance balance	$	1,047	$	10,251	$	364	$	360	$	202	$	12,224

Nine Months Ended
September 30, 2013			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,236	$	14,815	$	501	$	442	$	271	$	17,265
Provision for loan losses		(95)		(1,175)		(81)		90		(64)		(1,325)
Charge-offs		(142)		(3,528)		(73)		(209)		(102)		(4,054)
Recoveries		48		139		17		37		97		338
Total ending allowance balance	$	1,047	$	10,251	$	364	$	360	$	202	$	12,224

15

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

Three Months Ended
September 30, 2012			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,483	$	12,169	$	803	$	525	$	320	$	15,300
Provision for loan losses		(156)		2,831		16		37		(57)		2,671
Change in allowance associated with probable
branch divestitures		18		212		(30)		1		-		201
Charge-offs		(126)		(234)		-		(53)		(58)		(471)
Recoveries		13		51		-		(39)		98		123
Total ending allowance balance	$	1,232	$	15,029	$	789	$	471	$	303	$	17,824

Nine Months Ended
September 30, 2012			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,422	$	13,830	$	922	$	610	$	397	$	17,181
Provision for loan losses		66		4,504		(36)		135		(71)		4,598
Change in allowance associated with probable
branch divestitures		(7)		(369)		(36)		(56)		-		(468)
Charge-offs		(313)		(3,038)		(62)		(229)		(157)		(3,799)
Recoveries		64		102		1		11		134		312
Total ending allowance balance	$	1,232	$	15,029	$	789	$	471	$	303	$	17,824

We did not implement any changes to our allowance related accounting policies or methodology during the current period.

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of September 30, 2013 and 2012 and December 31, 2012:

September 30, 2013			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	197	$	3,550	$	68	$	51	$	-	$	3,866
Collectively evaluated for impairment		850		6,701		296		309		202		8,358
Total ending allowance balance	$	1,047	$	10,251	$	364	$	360	$	202	$	12,224
Loans:
Loans individually evaluated for impairment	$	1,353	$	40,629	$	3,015	$	620	$	-	$	45,617
Loans collectively evaluated for impairment		19,041		246,874		98,266		53,368		12,938		430,487
Total ending loans balance	$	20,394	$	287,503	$	101,281	$	53,988	$	12,938	$	476,104

December 31, 2012			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	252	$	7,593	$	86	$	51	$	-	$	7,982
Collectively evaluated for impairment		984		7,222		415		391		271		9,283
Total ending allowance balance	$	1,236	$	14,815	$	501	$	442	$	271	$	17,265
Loans:
Loans individually evaluated for impairment	$	1,071	$	43,513	$	213	$	188	$	-	$	44,985
Loans collectively evaluated for impairment		18,860		277,372		109,812		57,700		16,211		479,955
Total ending loans balance	$	19,931	$	320,885	$	110,025	$	57,888	$	16,211	$	524,940

16

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

September 30, 2012			Commercial		Residential		Consumer &		Indirect
	Commercial		Real Estate		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	229	$	8,000	$	378	$	95	$	7	$	8,709
Collectively evaluated for impairment		1,003		7,029		411		376		296		9,115
Loans held for sale		-		-		-		-		-		-
Total ending allowance balance	$	1,232	$	15,029	$	789	$	471	$	303	$	17,824
Loans:
Loans individually evaluated for impairment	$	1,029	$	57,655	$	1,093	$	255	$	57	$	60,089
Loans collectively evaluated for impairment		20,070		303,891		112,800		58,117		18,423		513,301
Loans held for sale		(775)		(36,878)		(3,583)		(5,616)		-		(46,852)
Total ending loans balance	$	20,324	$	324,668	$	110,310	$	52,756	$	18,480	$	526,538

The following tables’ present loans individually evaluated for impairment by class of loans as of September 30, 2013 and 2012 and December 31, 2012. The difference between the unpaid principal balance and recorded investment represents partial write downs/charge offs taken on individual impaired credits. The recorded investment and average recorded investment in loans exclude accrued interest receivable and loan origination fees.

							Three Months Ended						Nine Months Ended
							September 30, 2013						September 30, 2013
September 30, 2013	Unpaid				Allowance for		Average		Interest		Cash Basis		Average			Interest		Interest
	Principal		Recorded		Loan Losses		Recorded		Income		Interest		Recorded			Income		Income
(Dollars in thousands)	Balance		Investment		Allocated		Investment		Recognized		Recognized		Investment			Recognized		Recognized
With no related allowance recorded:
Commercial	$	1,177	$	973	$	-	$	1,001	$	9	$	9	$	815	$	18	$	18
Commercial Real Estate:
Land Development		2,220		2,195		-		2,253		27		27		3,125		114		114
Building Lots		477		212		-		212		-		-		212		-		-
Other		25,475		20,048		-		14,964		161		161		14,042		444		444
Residential Mortgage		2,525		2,525		-		2,733		21		21		2,212		45		45
Consumer and Home Equity		357		357		-		376		3		3		293		6		6
Indirect Consumer		-		-		-		-		-		-		-		-		-
With an allowance recorded:
Commercial		380		380		197		283		2		2		310		7		7
Commercial Real Estate:
Land Development		2,206		2,206		1,015		2,568		31		31		2,621		95		95
Building Lots		-		-		-		-		-		-		-		-		-
Other		15,970		15,968		2,535		18,183		195		195		18,980		599		599
Residential Mortgage		514		490		68		484		4		4		375		8		8
Consumer and Home Equity		281		263		51		266		2		2		269		6		6
Indirect Consumer		-		-		-		-		-		-		-		-		-
Total	$	51,582	$	45,617	$	3,866	$	43,323	$	455	$	455	$	43,254	$	1,342	$	1,342

17

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

December 31, 2012	Unpaid				Allowance for		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest
(Dollars in thousands)	Balance		Investment		Allocated		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	588	$	588	$	-	$	1,070	$	39	$	39
Commercial Real Estate:
Land Development		5,595		4,873		-		5,728		237		237
Building Lots		477		212		-		810		14		14
Other		22,121		16,500		-		25,051		961		961
Residential Mortgage		-		-		-		-		-		-
Consumer and Home Equity		-		-		-		-		-		-
Indirect Consumer		-		-		-		-		-		-
With an allowance recorded:
Commercial		483		483		252		564		21		21
Commercial Real Estate:
Land Development		2,674		2,674		899		2,436		101		101
Building Lots		-		-		-		191		3		3
Other		19,254		19,254		6,694		20,075		772		772
Residential Mortgage		213		213		86		1,191		24		24
Consumer and Home Equity		188		188		51		260		6		6
Indirect Consumer		-		-		-		54		1		1
Total	$	51,593	$	44,985	$	7,982	$	57,430	$	2,179	$	2,179

							Three Months Ended						Nine Months Ended
							September 30, 2012						September 30, 2012
September 30, 2012	Unpaid				Allowance for		Average		Interest		Cash Basis		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest		Recorded		Income		Interest
(Dollars in thousands)	Balance		Investment		Allocated		Investment		Recognized		Recognized		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	844	$	722	$	-	$	857	$	6	$	6	$	1,191	$	34	$	34
Commercial Real Estate:
Land Development		8,780		6,290		-		6,031		71		71		5,941		177		177
Building Lots		1,036		683		-		857		7		7		959		13		13
Other		18,577		15,911		-		22,319		222		222		27,189		781		781
Residential Mortgage		-		-		-		-		-		-		-		-		-
Consumer and Home Equity		-		-		-		-		-		-		-		-		-
Indirect Consumer		-		-		-		-		-		-		-		-		-
With an allowance recorded:
Commercial		307		307		229		356		3		3		584		17		17
Commercial Real Estate:
Land Development		1,950		1,950		316		1,345		16		16		2,377		71		71
Building Lots		-		-		-		-		-		-		238		3		3
Other		34,027		32,821		7,684		26,524		264		264		20,281		583		583
Residential Mortgage		1,119		1,093		378		1,096		5		5		1,436		29		29
Consumer and Home Equity		255		255		95		279		1		1		278		4		4
Indirect Consumer		57		57		7		48		-		-		68		1		1
Total	$	66,952	$	60,089	$	8,709	$	59,712	$	595	$	595	$	60,542	$	1,713	$	1,713

18

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

The following tables present the recorded investment in restructured, non-accrual and loans past due over 90 days still on accrual by class of loans as of September 30, 2013 and December 31, 2012.

					Restructured
					Loans Past Due		Loans Past Due
September 30, 2013					Over 90 Days		Over 90 Days		Non-Accrual
	Restructured on		Restructured on		Still		Still		Excluding
(Dollars in thousands)	Non-Accrual Status		Accrual Status		Accruing		Accruing		Restructured
Commercial	$	-	$	183	$	-	$	-	$	434
Commercial Real Estate:
Land Development		-		1,892		-		-		302
Building Lots		-		-		-		-		212
Other		7,819		17,223		4,837		2,238		4,115
Residential Mortgage		108		192		-		-		1,162
Consumer and Home Equity		-		97		-		-		262
Indirect Consumer		-		-		-		-		24
Total	$	7,927	$	19,587	$	4,837	$	2,238	$	6,511

					Restructured
					Loans Past Due		Loans Past Due
December 31, 2012					Over 90 Days		Over 90 Days		Non-Accrual
	Restructured on		Restructured on		Still		Still		Excluding
(Dollars in thousands)	Non-Accrual Status		Accrual Status		Accruing		Accruing		Restructured
Commercial	$	31	$	221	$	-	$	-	$	562
Commercial Real Estate:
Land Development		675		3,053		-		-		695
Building Lots		-		170		-		-		212
Other		9,047		19,080		-		-		9,356
Residential Mortgage		-		303		-		-		827
Consumer and Home Equity		-		24		-		-		37
Indirect Consumer		-		-		-		-		13
Total	$	9,753	$	22,851	$	-	$	-	$	11,702

The following table presents the aging of the recorded investment in past due loans as of September 30, 2013 and December 31, 2012 by class of loans:

September 30, 2013	30-59		60-89		Greater than
	Days		Days		90 Days		Total		Loans Not
(Dollars in thousands)	Past Due		Past Due		Past Due		Past Due		Past Due		Total
Commercial	$	-	$	-	$	434	$	434	$	19,960	$	20,394
Commercial Real Estate:
Land Development		2,206		-		302		2,508		19,887		22,395
Building Lots		-		-		212		212		1,387		1,599
Other		3,861		23		19,009		22,893		240,616		263,509
Residential Mortgage		279		923		1,270		2,472		98,809		101,281
Consumer and Home Equity		324		28		262		614		53,374		53,988
Indirect Consumer		141		30		24		195		12,743		12,938
Total	$	6,811	$	1,004	$	21,513	$	29,328	$	446,776	$	476,104

December 31, 2012	30-59		60-89		Greater than
	Days		Days		90 Days		Total		Loans Not
(Dollars in thousands)	Past Due		Past Due		Past Due		Past Due		Past Due		Total
Commercial	$	-	$	95	$	562	$	657	$	19,274	$	19,931
Commercial Real Estate:
Land Development		361		-		1,228		1,589		26,721		28,310
Building Lots		-		-		212		212		1,939		2,151
Other		1,264		1,239		13,449		15,952		274,472		290,424
Residential Mortgage		3,588		995		827		5,410		104,615		110,025
Consumer and Home Equity		351		255		45		651		57,237		57,888
Indirect Consumer		246		130		13		389		15,822		16,211
Total	$	5,810	$	2,714	$	16,336	$	24,860	$	500,080	$	524,940

19

  

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

Troubled Debt Restructurings (TDR):

We have allocated $1.5 million and $3.1 million of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2013 and December 31, 2012. We are not committed to lend additional funds to debtors whose loans have been modified in a troubled debt restructuring. Specific reserves are generally assessed prior to loans being modified as a TDR, as most of these loans migrate from our internal watch list and have been specifically reserved for as part of our normal reserving methodology.

During the quarter and nine month periods ending September 30, 2013 and September 30, 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan.

Modifications involving a reduction of the stated interest rate of the loan were for periods ranging from six months to one year. Modifications involving an extension of the maturity date were for periods ranging from three to six months.

The following tables present loans by class modified as troubled debt restructurings that occurred during the periods ending September 30, 2013 and 2012:

	Three Months Ended					Three Months Ended
	September 30, 2013					September 30, 2012
		Pre-Modification		Post-Modification			Pre-Modification		Post-Modification
		Outstanding		Outstanding			Outstanding		Outstanding
	Number	Recorded		Recorded		Number	Recorded		Recorded
(Dollars in thousands)	of Loans	Investment		Investment		of Loans	Investment		Investment
Troubled Debt Restructurings:
Commercial	-	$	-	$	-	-	$	-	$	-
Commercial Real Estate:
Land Development	-		-		-	-		-		-
Building Lots	-		-		-	-		-		-
Other	-		-		-	1		58		58
Residential Mortgage	-		-		-	-		-		-
Consumer and Home Equity	-		-		-	-		-		-
Indirect Consumer	-		-		-	-		-		-
Total	-	$	-	$	-	1	$	58	$	58

	Nine Months Ended					Nine Months Ended
	September 30, 2013					September 30, 2012
		Pre-Modification		Post-Modification			Pre-Modification		Post-Modification
		Outstanding		Outstanding			Outstanding		Outstanding
	Number	Recorded		Recorded		Number	Recorded		Recorded
(Dollars in thousands)	of Loans	Investment		Investment		of Loans	Investment		Investment
Troubled Debt Restructurings:
Commercial	-	$	-	$	-	1	$	1,094	$	1,094
Commercial Real Estate:
Land Development	-		-		-	3		4,143		4,002
Building Lots	-		-		-	2		370		370
Other	5		3,512		3,512	6		1,175		1,175
Residential Mortgage	-		-		-	-		-		-
Consumer and Home Equity	2		74		74	-		-		-
Indirect Consumer	-		-		-	-		-		-
Total	7	$	3,586	$	3,586	12	$	6,782	$	6,641

20

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

The troubled debt restructurings described above increased the allowance for loan losses allocated to troubled debt restructurings by $242,000 and $78,000 for the three and nine months ended September 30, 2013. The troubled debt restructurings described above decreased the allowance for loan losses allocated to troubled debt restructurings by $7,000 and $6,000 for the three and nine months ended September 30, 2012 primarily due to loan pay downs. Typically, these loans had allocated allowance prior to their formal modification. The troubled debt restructurings described above resulted in charge-offs of $0 and $141,000 for the three and nine month periods ended September 30, 2012. There were no charge-offs recorded on the troubled debt restructurings described above for the 2013 periods.

The following tables present loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the periods ending September 30, 2013 and 2012:

	Three Months Ended			Three Months Ended
	September 30, 2013			September 30, 2012
	Number	Recorded		Number	Recorded
(Dollars in thousands)	of Loans	Investment		of Loans	Investment
Troubled Debt Restructurings:
Commercial	-	$	-	-	$	-
Commercial Real Estate:
Land Development	-		-	-		-
Building Lots	-		-	-		-
Other	-		-	-		-
Real Estate Construction	-		-	-		-
Residential Mortgage	-		-	-		-
Consumer and Home Equity	-		-	-		-
Indirect Consumer	-		-	-		-
Total	-	$	-	-	$	-

	Nine Months Ended			Nine Months Ended
	September 30, 2013			September 30, 2012
	Number	Recorded		Number	Recorded
(Dollars in thousands)	of Loans	Investment		of Loans	Investment
Troubled Debt Restructurings:
Commercial	-	$	-	-	$	-
Commercial Real Estate:
Land Development	-		-	2		3,278
Building Lots	-		-	-		-
Other	-		-	1		10,068
Real Estate Construction	-		-	-		-
Residential Mortgage	-		-	-		-
Consumer and Home Equity	-		-	-		-
Indirect Consumer	-		-	-		-
Total	-	$	-	3	$	13,346

For disclosure purposes, a loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $1.8 million and $1.7 million for the three and nine months ended September 30, 2012. The troubled debt restructurings described above resulted in charge-offs of $141,000 for the three and nine month periods ended September 30, 2012.

21

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

Credit Quality Indicators:

We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk. This analysis includes commercial and commercial real estate loans. We also evaluate credit quality on residential mortgage, consumer and home equity and indirect consumer loans based on the aging status and payment activity of the loan. This analysis is performed on a monthly basis. We use the following definitions for risk ratings:

Criticized: Loans classified as criticized have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in our credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss: Loans classified as loss are considered non-collectible and their continuance as bankable assets is not warranted.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. Loans listed as not rated are included in groups of homogeneous loans. For our residential mortgage, consumer and home equity, and indirect consumer homogeneous loans, we also evaluate credit quality based on the aging status of the loan, which was previously presented, and by payment activity.

As of September 30, 2013and December 31, 2012, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

September 30, 2013
(Dollars in thousands)	Not Rated		Pass		Criticized		Substandard		Doubtful		Loss		Total
Commercial	$	-	$	19,041	$	-	$	1,353	$	-	$	-	$	20,394
Commercial Real Estate:
Land Development		-		14,706		3,288		4,401		-		-		22,395
Building Lots		-		931		456		212		-		-		1,599
Other		-		209,660		17,793		36,056		-		-		263,509
Residential Mortgage		97,421		-		845		3,015		-		-		101,281
Consumer and Home Equity		53,192		-		73		723		-		-		53,988
Indirect Consumer		12,899		-		1		38		-		-		12,938
Total	$	163,512	$	244,338	$	22,456	$	45,798	$	-	$	-	$	476,104

December 31, 2012
(Dollars in thousands)	Not Rated		Pass		Criticized		Substandard		Doubtful		Loss		Total
Commercial	$	-	$	16,736	$	2,000	$	1,195	$	-	$	-	$	19,931
Commercial Real Estate:
Land Development		-		17,744		3,059		7,507		-		-		28,310
Building Lots		-		1,447		492		212		-		-		2,151
Other		-		235,954		18,297		36,173		-		-		290,424
Residential Mortgage		105,148		-		442		4,435		-		-		110,025
Consumer and Home Equity		56,593		-		569		726		-		-		57,888
Indirect Consumer		16,129		-		10		72		-		-		16,211
Total	$	177,870	$	271,881	$	24,869	$	50,320	$	-	$	-	$	524,940

22

  

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

The following table presents the unpaid principal balance in residential mortgage, consumer and home equity and indirect consumer loans based on payment activity as of September 30, 2013 and December 31, 2012:

September 30, 2013	Residential		Consumer &		Indirect
(Dollars in thousands)	Mortgage		Home Equity		Consumer
Performing	$	100,011	$	53,726	$	12,914
Restructured on non-accrual		108		-		-
Non-accrual		1,162		262		24
Total	$	101,281	$	53,988	$	12,938

December 31, 2012	Residential		Consumer &		Indirect
(Dollars in thousands)	Mortgage		Home Equity		Consumer
Performing	$	109,198	$	57,851	$	16,198
Restructured on non-accrual		-		-		-
Non-accrual		827		37		13
Total	$	110,025	$	57,888	$	16,211

5. REAL ESTATE ACQUIRED THROUGH FORECLOSURE

A summary of the real estate acquired through foreclosure activity is as follows:

	September 30,		December 31,
(Dollars in thousands)	2013		2012
Beginning balance, January 1,	$	22,286	$	29,083
Additions		2,262		18,100
Net proceeds from sale of properties		(13,883)		(19,250)
Writedowns		(1,585)		(5,147)
Change in valuation allowance		(221)		(500)
Ending balance	$	8,859	$	22,286

A summary of the real estate acquired through foreclosure valuation allowance activity is as follows:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
(Dollars in thousands)
Beginning balance	$	721	$	-	$	500	$	-
Provision		365		-		1,957		-
Writedowns and loss on sale		(365)		-		(1,736)		-
Ending balance	$	721	$	-	$	721	$	-

Real estate acquired through foreclosure expense which consists primarily of property management expenses was $452,000 and $638,000 for the three months ended September 30, 2013 and 2012, and $1.3 million and $3.3 million for the nine months ended September 30, 2013 and 2012, respectively.

23

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

6. INCOME TAXES

A full valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a full valuation allowance, we considered various factors including our four year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and operating results in 2013, 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order. Based on this assessment, we concluded that a valuation allowance was necessary at September 30, 2013 and December 31, 2012.

7. EARNINGS (LOSS) PER SHARE

The reconciliation of the numerators and denominators of the basic and diluted EPS is as follows:

	Three Months Ended				Nine Months Ended
(Amounts in thousands,	September 30,				September 30,
except per share data)	2013		2012		2013		2012
Basic:
Net income/(loss)	$	1,467	$	(751)	$	463	$	(5,180)
Less:
Preferred stock dividends		(250)		(250)		(750)		(750)
Accretion on preferred stock discount		(14)		(14)		(41)		(41)
Net income (loss) available to common shareholders	$	1,203	$	(1,015)	$	(328)	$	(5,971)
Weighted average common shares		4,860		4,773		4,816		4,767
Diluted:
Weighted average common shares		4,860		4,773		4,816		4,767
Dilutive effect of stock options and warrants		45		-		-		-
Weighted average common and incremental shares		4,905		4,773		4,816		4,767
Earnings (Loss) Per Common Share:
Basic	$	0.25	$	(0.21)	$	(0.07)	$	(1.25)
Diluted	$	0.25	$	(0.21)	$	(0.07)	$	(1.25)

Since the Corporation is reporting a net loss available to common shareholders for the nine month 2013 period and the 2012 periods, no stock options or warrants were evaluated for dilutive purposes. Stock options for 238,000 shares of common stock were not included in the three month September 30, 2013 computation of diluted earnings per share because their impact was anti-dilutive. The common stock warrant for 215,983 shares was not included in the three month September 30, 2013 computation of diluted earnings per share because its impact was also anti-dilutive. 

8. STOCK BASED COMPENSATION PLAN

Our 2006 Stock Option and Incentive Compensation Plan, which is stockholder approved, authorizes us to grant restricted stock and incentive or non-qualified stock options to key employees and directors for a total of 763,935 shares of our common stock. We believe that the ability to award stock options and other forms of stock-based incentive compensation can assist us in attracting and retaining key employees. Stock-based incentive compensation is also a means to align the interests of key employees with those of our stockholders by providing awards intended to reward recipients for our long-term growth. Options to purchase shares generally vest over periods of one to five years and expire ten years after the date of grant. We issue new shares of common stock upon the exercise of stock options. If options or awards granted under the 2006 Plan expire or terminate for any reason without having been exercised in full or released from restriction, the corresponding shares shall again be available for option or award for the purposes of the Plan. At September 30, 2013, options and restricted stock available for future grant under the 2006 Plan totaled 157,630. 

 

24

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

8. STOCK BASED COMPENSATION PLAN – (Continued)

Stock Options – The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses various weighted-average assumptions. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on the fluctuation in the price of a share of stock over the period for which the option is being valued and the expected life of the options granted represents the period of time the options are expected to be outstanding.

The weighted-average assumptions for options granted during the nine months ended September 30, 2013 and the resulting estimated weighted average fair value per share is presented below.

	September 30,
	2013
Assumptions:
Risk-free interest rate		2.05	%
Expected dividend yield		-	%
Expected life (years)		10
Expected common stock
market price volatility		65	%
Estimated fair value per share	$	1.96

A summary of option activity under the 2006 Plan for the nine months ended September 30, 2013 is presented below:

					Weighted
			Weighted		Average
	Number		Average		Remaining	Aggregate
	of		Exercise		Contractual	Intrinsic
	Options		Price		Term	Value
						(Dollars In Thousands)
Outstanding, beginning of period		392,740	$	9.16
Granted during period		149,000		2.70
Terminated during period		(132,390)		17.95
Forfeited during period		(11,350)		4.18
Exercised during period		(200)		2.05
Outstanding, end of period		397,800	$	3.96	8.3	$	449
Eligible for exercise at period end		85,960	$	7.81	6.9	$	55

The total intrinsic value of options exercised during the nine month 2013 period was $364. The total cash received from options exercised during the nine month 2013 period was $410.There were 132,390 out of the money options that were settled during the third quarter for $1,300.There were no options exercised, modified or cash settled during the 2012 period.There was no tax benefit recognized from the option exercises as they are considered incentive stock options.Management expects all outstanding unvested options will vest. 

Compensation cost related to options granted under the 2006 Plan that was charged against earnings for the periods ended September 30, 2013 and 2012 was $113,000 and $86,000. As of September 30, 2013 there was $465,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 2006 Plan. That cost is expected to be recognized over a weighted-average period of 3.5 years.

Restricted Stock – On June 28, 2013, we granted 20,500 shares of restricted common stock at the current market price of $3.39. The restricted stock will vest over a five year period and will become fully vested on June 28, 2018, provided that the recipient has continued to perform substantial services for the Bank through that date. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date of vesting. The transfer restrictions will expire upon the occurrence of a change of control event or upon the recipient’s death or disability. On the same date, we entered into an agreement with the recipient of the newly issued restricted stock to terminate 17,250 unvested shares of long-term restricted stock that had been awarded to him on February 7, 2013. Upon the sale of our Senior Preferred Shares by the U.S. Treasury on April 29, 2013 at a discount to face amount, the 17,250 shares had become subject to permanent restrictions on transfer by the holder, who elected to terminate the shares.

25

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

8. STOCK BASED COMPENSATION PLAN – (Continued)

On September 19, 2012 our board of directors adopted the 2012 Non-Employee Director Equity Compensation Program (the “Director Program”). The Director Program enables us to compensate non-employee directors for their service with stock awards. We currently do not pay cash compensation to non-employee directors pursuant to agreements with bank regulatory agencies. The board has reserved 200,000 of the shares authorized for issuance under our shareholder approved 2006 Stock Option and Incentive Compensation Plan for stock awards under the Director Program.

The Director Program provides that each non-employee director elected or continuing in office on the date of each annual meeting of the Corporation’s shareholders will automatically receive an award of restricted stock on that date having a value of $30,000, based on the closing sale price per share of the Corporation’s common stock on the award date, rounded up to the next whole number. Accordingly, on May 15, 2013, the Company’s eight non-employee directors each received an award of 9,934 restricted shares, or 79,472 shares in total, that vest at the close of business on the day immediately preceding the date of the 2014 annual meeting of the Corporation’s shareholders, provided that the recipient has continued to serve as a member of the Board as of the date of vesting. The recipient may not transfer, pledge or dispose of the restricted stock until the close of business on the day immediately preceding the first anniversary of the award date. The transfer restrictions will also expire upon the occurrence of a Change of Control, as defined in the Plan, or upon the recipient’s death or disability. If a director ceases to serve as a member of the board for any reason, that director will automatically forfeit any unvested shares subject to an award. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date the transfer restrictions expire.

A summary of changes in our non-vested restricted shares for the nine months ended September 30, 2013 is presented below:

			Weighted
			Average
	Non-vested		Grant Date
	Shares		Fair Value
Outstanding, beginning of period		32,964	$	3.64
Granted during period		122,972		3.05
Vested during period		(76,217)		3.29
Terminated during period		(17,250)		2.84
Forfeited during period		-		-
Outstanding, end of period		62,469	$	3.13

Compensation cost related to restricted stock granted under the 2006 Plan that was charged against earnings for the periods ended September 30, 2013 and 2012 was $281,000 and $116,000, respectively. As of September 30, 2013 there was $165,000 of total unrecognized compensation cost related to non-vested shares granted under the Plan. That cost is expected to be recognized over the remaining vesting period of 2.4 years.

26

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9.            FAIR VALUE

U.S. GAAP defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and establishes a fair value hierarchy that prioritizes the use of inputs used in valuation methodologies into the following three levels:

Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets. A quoted price in an active market provides the most reliable evidence of fair value and shall be used to measure fair value whenever available.

Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

Level 3: Significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

We used the following methods and significant assumptions to estimate the fair value.

Available-for-sale securities: For securities where quoted prices are not available, fair values are calculated on market prices of similar securities or determined by a matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs).

Impaired Loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Once a loan is considered impaired, it is evaluated by a member of the Credit Department on at least a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by us. Once received, a member of the Credit Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with via independent data sources such as recent market data or industry-wide statistics.

27

 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9.            FAIR VALUE - (Continued)

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Assets measured at fair value on a recurring basis are summarized below: There were no transfers between Level 1 and Level 2 during the periods presented.

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	September 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2013		(Level 1)		(Level 2)		(Level 3)
Assets:
Government-sponsored    mortgage-backed    residential	$	114,550	$	-	$	114,550	$	-
Government-sponsored    collateralized mortgage    obligations		77,742		-		77,742		-
Asset backed-    collateralized loan    obligations		32,656		-		32,656		-
State and municipal		12,666		-		12,666		-
Corporate bonds		52,569		-		52,569		-
Total	$	290,183	$	-	$	290,183	$	-

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2012		(Level 1)		(Level 2)		(Level 3)
Assets:
U.S. Treasury and agencies	$	8,278	$	-	$	8,278	$	-
Government-sponsored     mortgage-backed     residential		144,889		-		144,889		-
Government-sponsored     collateralized mortgage     obligations		150,147		-		150,147		-
Private asset backed		5,132		-		5,132		-
State and municipal		12,718		-		12,718		-
Corporate bonds		32,967		-		32,967		-
Total	$	354,131	$	-	$	354,131	$	-

We conduct a thorough review of fair value hierarchy classifications on a quarterly basis. Reclassification of certain financial instruments may occur when input observability changes.

The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended September 30, 2012. The level 3 assets consist of trust preferred securities which were called or sold in the fourth quarter of 2012. We did not have any Level 3 assets measured at fair value on a recurring basis at September 30, 2013.

	Fair Value Measurements		Fair Value Measurements
	Using Significant		Using Significant
	Unobservable Inputs		Unobservable Inputs
	(Level 3)		(Level 3)
	Three Months Ended		Nine Months Ended
	September 30,		September 30,
(Dollars in thousands)	2012		2012
Beginning balance	$	266	$	264
Total gains or losses:
Impairment charges on securities		-		-
Included in other comprehensive income		16		18
Purchases		-		-
Sales or calls		(1)		(1)
Settlements		-		-
Transfers in and/or out of Level 3		-		-
Ending balance	$	281	$	281

28

  

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9.            FAIR VALUE - (Continued)

There were no changes in unrealized gains and losses recorded in earnings for the quarter and nine months ended September 30, 2013 for Level 3 assets and liabilities that are still held at September 30, 2013.

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

Assets measured at fair value on a nonrecurring basis are summarized below:

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	September 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2013		(Level 1)		(Level 2)		(Level 3)
Assets:
Impaired loans:
Commercial	$	183	$	-	$	-	$	183
Commercial Real Estate:
Land Development		1,191		-		-		1,191
Other		13,433		-		-		13,433
Residential Mortgage		422		-		-		422
Consumer and Home Equity		212		-		-		212
Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development		918		-		-		918
Other		2,951		-		-		2,951
Residential Mortgage		483		-		-		483

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2012		(Level 1)		(Level 2)		(Level 3)
Assets:
Impaired loans:
Commercial	$	231	$	-	$	-	$	231
Commercial Real Estate:
Land Development		1,775		-		-		1,775
Other		12,560		-		-		12,560
Residential Mortgage		127		-		-		127
Consumer and Home Equity		137		-		-		137
Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development		2,459		-		-		2,459
Building Lots		2,220		-		-		2,220
Other		8,350		-		-		8,350
Residential Mortgage		224		-		-		224

29

 NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $19.3 million, with a valuation allowance of $3.9 million, resulting in an additional provision for loan losses of $32,000 for the quarter ended September 30, 2013 and a reversal of provision for loan losses of $310,000 for the nine months ended September 30, 2013. Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $35.1 million, with a valuation allowance of $5.0 million, resulting in an additional provision for loan losses of $600,000 and $2.5 million for the three and nine months ended September 30, 2012. Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisers and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the estimated cost to replace the current property after considering adjustments for depreciation. Values of the market comparison approach evaluate the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investors required return. The final value is a reconciliation of these three approaches and takes into consideration any other factors management deems relevant to arrive at a representative fair value.

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property. Many of the appraisals utilize an income approach, such as the discounted cash flow method, to estimate future income and profits or cash flows. Appraisals may also utilize a single valuation approach or a combination of approaches including a market comparison approach, where prices and other relevant information generated by market transactions involving identical or comparable properties are used to determine fair value. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Fair value adjustments of $300,000 and $1.8 million were made to real estate owned during the quarter and nine months ended September 30, 2013. Fair value adjustments of $1.4 million and $4.9 million were made to real estate owned during the quarter and nine months ended September 30, 2012.

30

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at September 30, 2013.

	Fair		Valuation	Unobservable	Range (Weighted
(Dollars in thousands)	Value		Technique(s)	Input(s)	Average)
Impaired loans:
Commercial	$	183	Income approach	Discount or capitalization rate	1.25% (1)
Commercial Real Estate:
Land Development		1,191	Income approach	Discount or capitalization rate	0.00%-25.00% (23.23%)
Other		12,435	Income approach	Discount or capitalization rate	1.25%-9.00% (8.73%)
		998	Sales comparison approach	Adjustment for differences between      comparable sales	0.00%-10.00% (2.29%)
Residential Mortgage		422	Sales comparison approach	Adjustment for differences between      comparable sales	0.00%-3.87% (1.07%)
Consumer and Home Equity		212	Sales comparison approach	Adjustment for differences between      comparable sales	1.80%-2.25% (1.87%)
Real estate acquired through foreclosure:
Commercial Real Estate:
Land Development		886	Income approach	Discount or capitalization rate	8.50%-29.00% (23.97%)
		32	Sales comparison approach	Adjustment for differences between      comparable sales	0.00% (1)
Other		1,009	Income approach	Discount or capitalization rate	8.70%-10.00% (9.61%)
		1,942	Sales comparison approach	Adjustment for differences between      comparable sales	2.75%-20.00% (15.24%)
Residential Mortgage		483	Sales comparison approach	Adjustment for differences between      comparable sales	0.00%-18.00% (0.82%)

(1) Unobservable inputs with a single discount listed include only one property.

31

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

Fair Value of Financial Instruments

The estimated fair value of financial instruments, not previously presented, is as follows:

			September 30, 2013
(Dollars in thousands)	Carrying		Fair Value Measurements
	Value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	31,517	$	31,517	$	5,970	$	25,547	$	-
Mortgage loans held for sale		1,068		1,085		-		1,085		-
Loans, net		448,366		452,066		-		-		452,066
Accrued interest receivable		2,283		2,283		-		-		2,283
FHLB stock		4,430		N/A		N/A		N/A		N/A
Financial liabilities:
Deposits		746,878		708,766		-		708,766		-
Advances from Federal Home Loan Bank		38,424		39,445		-		39,445		-
Subordinated debentures		18,000		12,200		-		-		12,200
Accrued interest payable		4,137		4,137		-		4,137		-

			December 31, 2012
(Dollars in thousands)	Carrying		Fair Value Measurements
	Value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	63,103	$	63,103	$	6,468	$	56,635	$	-
Mortgage loans held for sale		3,887		3,967		-		3,967		-
Loans, net		492,740		493,998		-		-		493,998
Accrued interest receivable		2,690		2,690		-		-		2,690
FHLB stock		4,805		N/A		N/A		N/A		N/A
Financial liabilities:
Deposits		922,620		934,637		-		934,637		-
Advances from Federal Home Loan Bank		12,596		13,944		-		13,944		-
Subordinated debentures		18,000		12,695		-		-		12,695
Accrued interest payable		3,121		3,121		-		3,121		-

The methods and assumptions, not previously presented, used to estimate fair values are described below:

(a) Cash and due from banks

The carrying amount of cash on hand approximates fair value and is classified as a Level 1. The carrying amount of cash due from bank accounts is classified as a Level 2.

(b) Mortgage loans held for sale

The fair value of mortgage loans held for sale is estimated based upon the binding contracts and quotes from third party investors resulting in a Level 2 classification.

(c) Loans, net

Fair values of loans are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price.

32

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 

9. FAIR VALUE - (Continued)

(d) FHLB Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

(e) Deposits

The carrying amounts of variable rate interest bearing deposits approximate their fair values at the reporting date resulting in a Level 2 classification.Fair values for fixed rate interest bearing deposits are estimated using a discounted cash flows calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities on time deposits resulting in a Level 2 classification.

(f) Advances from Federal Home Loan Bank

The fair value of the FHLB advances is obtained from the FHLB and is calculated by discounting contractual cash flow using an estimated interest rate based on the current rates available to us for debt of similar remaining maturities and collateral terms resulting in a Level 2 classification.

(g) Subordinated debentures

The fair value for subordinated debentures is calculated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

(h) Accrued interest receivable/payable

The carrying amounts of accrued interest approximate fair value resulting in a Level 3 classification based on the level of the asset or liability with which the accrual is associated.

(i) Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

33

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

10. SUBORDINATED DEBENTURES

On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes relating to outstanding trust preferred securities.Together, the junior subordinated notes had an outstanding principal amount of $18 million.We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty.After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the statutory trusts, which are wholly owned subsidiaries of First Financial Service Corporation formed to issue the trust preferred securities, will likewise suspend the declaration and payment of dividends on the trust preferred securities.The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of September 30, 2013, we have deferred a total of twelve quarterly payments and these accrued but unpaid interest payments totaled $4.1 million.

11. PREFERRED STOCK

On January 9, 2009, we issued $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the United States Treasury under its Capital Purchase Program (“CPP”). The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares pay cumulative dividends quarterly at a rate of 5% per year for the first five years and will reset to a rate of 9% per year on January 9, 2014. The Senior Preferred Shares may be redeemed at any time, subject to prior approval from bank regulatory agencies. We also have the ability to defer dividend payments at any time, at our option.

Under the terms of our CPP stock purchase agreement, we also issued the Treasury a warrant to purchase an amount of our common stock equal to 15% of the aggregate amount of the Senior Preferred Shares, or $3 million.The warrant entitles Treasury to purchase 215,983 common shares at a purchase price of $13.89 per share.The initial exercise price for the warrant and the number of shares subject to the warrant were determined by reference to the market price of our common stock calculated on a 20-day trailing average as of December 8, 2008, the date Treasury approved our application.The warrant has a term of 10 years and is potentially dilutive to earnings per share.

Effective with the fourth quarter of 2010, we suspended payment of regular quarterly cash dividends on our Senior Preferred Shares.The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income attributable to common shareholders for financial statement purposes.As of September 30, 2013, we have deferred a total of twelve quarterly payments and these accrued but unpaid dividends totaled $3.2 million.

Participation in the CPP requires a participating institution to comply with a number of restrictions and provisions, including standards for executive compensation and corporate governance that apply only as long as the Senior Preferred Shares are held by Treasury and limitations on share repurchases and the declaration and payment of dividends on common shares. The standard terms of the CPP require that a participating financial institution limit the payment of dividends to the most recent quarterly amount prior to October 14, 2008, which is $0.19 per share in our case. This dividend limitation will remain in effect until the preferred shares are retired.

On April 29, 2013, Treasury sold our Senior Preferred Shares to six funds in an auction. Following the sale, the full $20 million stated value of our Senior Preferred Shares remains outstanding and our obligation to pay deferred and future dividends, currently at an annual rate of 5% and increasing to 9% in January 2014, continues until our Senior Preferred Shares are fully retired.

34

 

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

12. STOCKHOLDERS’ EQUITY

Regulatory Capital Requirements – The Corporation and the Bank are subject to regulatory capitalrequirements administered by federal banking agencies.Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices.Capital amounts and classifications are also subject to qualitative judgments by regulators.Failure to meet capital requirements can result in regulatory action.

Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized,undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition.If adequately capitalized, regulatory approval is required to accept brokered deposits.If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and 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 of Tier 1 capital (as defined) to average assets (as defined).

As a result of the Consent Order the Bank entered into with the FDIC and KDFI described in greater detail in Note 2, the Bank is categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized".

On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The 2012 Consent Order requires the Bank to achieve the same minimum capital ratios mandated by the January 2011 Consent Order, which are set forth below.See Note 2 for additional information.

Our actual and required capital amounts and ratios are presented below.

(Dollars in thousands)						For Capital					Required by
	Actual					Adequacy Purposes					Consent Order
As of September 30, 2013:	Amount		Ratio			Amount		Ratio			Amount		Ratio
Total risk-based capital (to risk-weighted assets)
Consolidated	$	68,533		11.88	%	$	46,164		8.00	%	$	69,246	12.00	%
Bank		75,542		13.09			46,161		8.00			69,241	12.00
Tier I capital (to risk-weighted assets)
Consolidated		57,677		10.00			23,082		4.00			N/A	N/A
Bank		68,258		11.83			23,080		4.00			N/A	N/A
Tier I capital (to average assets)
Consolidated		57,677		6.60			34,962		4.00			78,665	9.00
Bank		68,258		7.80			35,015		4.00			78,783	9.00

(Dollars in thousands)						For Capital					Required by
	Actual					Adequacy Purposes					Consent Order
As of December 31, 2012:	Amount		Ratio			Amount		Ratio				Amount	Ratio
Total risk-based capital (to risk-weighted assets)
Consolidated	$	68,791		11.36	%	$	48,438		8.00	%	$	72,657	12.00	%
Bank		73,951		12.21			48,439		8.00			72,658	12.00
Tier I capital (to risk-weighted assets)
Consolidated		57,471		9.49			24,219		4.00			N/A	N/A
Bank		66,256		10.94			24,219		4.00			N/A	N/A
Tier I capital (to average assets)
Consolidated		57,471		5.67			40,580		4.00			91,304	9.00
Bank		66,256		6.53			40,608		4.00			91,368	9.00

35

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

13. CHANGES IN AND RECLASSIFICATIONS FROM ACCUMULATED OTHERCOMPREHENSIVE INCOME

Changes in accumulated other comprehensive income by component consists of the following:

	Three Months Ended		Nine Months Ended
	September 30, 2013		September 30, 2013
	Unrealized Gains		Unrealized Gains
	and Losses on		and Losses on
	Available-for-Sale		Available-for-Sale
(Dollars in thousands)	Securities (1)		Securities (1)
Beginning balance	$	(7,285)	$	1,270
Other comprehensive income (loss) before reclassification		(1,438)		(9,766)
Amounts reclassified from accumulated other comprehensive income		(12)		(239)
Net other comprehensive income (loss)		(1,450)		(10,005)
Ending balance	$	(8,735)	$	(8,735)

(1) All amounts are net of tax.

Reclassifications out of accumulated other comprehensive income consists of the following:

Three months ended September 30, 2013

(Dollars in thousands)

	Amount
Details about	Reclassified From		Affected Line Item
Accumulated Other	Accumulated Other		in the
Comprehensive	Comprehensive		Consolidated
Income Components	Income		Statement of Operations
Unrealized gains and losses     on available-for-sale securities	$	235		Gain on sale of investments
		(223)		Loss on sale of investments
		12		Total before tax
		-		Income taxes/(benefits)
Total amount reclassified	$	12		Net income (loss)

Nine months ended September 30, 2013

(Dollars in thousands)

	Amount
Details about	Reclassified From		Affected Line Item
Accumulated Other	Accumulated Other		in the
Comprehensive	Comprehensive		Consolidated
Income Components	Income		Statement of Operations
Unrealized gains and losses
on available-for-sale securities	$	1,078		Gain on sale of investments
		(839)		Loss on sale of investments
		239		Total before tax
		-		Income taxes/(benefits)
Total amount reclassified	$	239		Net income (loss)

36

 

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

GENERAL

We operate 17 full-service banking centers in six contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area.Our markets range from Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown.Our markets are supported by a diversified industry base and have a regional population of over 1 million.We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky.We control in the aggregate, approximately, 19% of the deposit market share in our central Kentucky markets outside of Louisville.

We serve the needs and cater to the economic strengths of the local communities in which we operate, and we strive to provide a high level of personal and professional customer service. We offer a variety of financial services to our retail and commercial banking customers. These services include personal and corporate banking services and personal investment financial counseling services.

Through our personal investment financial counseling services, we offer a wide variety of non-insured investments including mutual funds, equity investments, and fixed and variable annuities. We invest in the wholesale capital markets to manage a portfolio of securities and use various forms of wholesale funding. The security portfolio contains a variety of instruments, including callable debentures, taxable and non-taxable debentures, fixed and adjustable rate mortgage backed securities, collateralized mortgage obligations and corporate securities.

Our results of operations depend primarily on net interest income, which is the difference between interest income from interest-earning assets and interest expense on interest-bearing liabilities. Our operations are also affected by non-interest income, such as service charges, loan fees, gains and losses from the sale of mortgage loans and revenue earned from bank owned life insurance. Our principal operating expenses, aside from interest expense, consist of compensation and employee benefits, occupancy costs, data processing expense, FDIC insurance premiums, costs associated with other real estate and provisions for loan losses.

The discussion and analysis section covers material changes in the financial condition since December 31, 2012 and material changes in the results of operations for the three and nine month periods ending September 30, 2013 as compared to 2012.It should be read in conjunction with "Management’s Discussion and Analysis of Financial Condition and Results of Operations" included in our Annual Report on Form 10-K for the period ended December 31, 2012.

OVERVIEW

Net income attributable to common shareholders for the quarter ended September 30, 2013 was $1.2 million or $0.25 per diluted common share compared to a net loss attributable to common shareholders of $1.0 million or $0.21 per diluted common share for the same period in 2012.Net loss attributable to common shareholders for the nine months ended September 30, 2013 was $328,000 or $0.07 per diluted common share compared to a net loss attributable to common shareholders of $6.0 million or $1.25 per diluted common share for the same period a year ago.

While still elevated, the level of non-performing assets is now at the lowest level since the first quarter of 2009.Compared to September 30, 2012, non-performing loans declined $10.2 million or 32%, non-performing assets declined $30.0 million or 50%, and classified and criticized assets declined $22.4 million or 25%. We sold twenty-nine OREO properties totaling $13.9 million during the 2013 period. The net proceeds received from the sale of several of these properties exceeded the carrying value on our books, and were a primary contributor to the changes in net income available to common shareholders.

Non-performing assets were $30.4 million or 3.57% of total assets at September 30, 2013 compared to $43.8 million or 4.35% of total assets at December 31, 2012.The decrease in non-performing assets is mainly attributable to a $13.4 million decrease in real estate acquired through foreclosure.Five

properties totaling $15.8 million make up 52% of the total non-performing assets.The properties range in value from $931,000 to $6.8 million and have an aggregate specific reserve for $182,000.

37

We anticipate that our level of real estate acquired through foreclosure will continue to decrease over the next several quarters as we continue to sell these properties, while inflow has slowed down substantially compared to 2010 and 2011.The lower values on the appraisals and reviews of properties appraised within 2013 resulted in $1.6 million in write downs on OREO compared to $4.9 million in total write downs recorded during the 2012 nine month period.We believe that we have written down OREO values to levels that will facilitate their liquidation, as indicated by recent sales.

As economic conditions improved and collateral values stabilized in 2012 and the first nine months of 2013, our provision for loan losses during this period has been much lower than in 2011. The allowance for loan losses to total loans was 2.57% at September 30, 2013 while annualized net charge-offs to average loans totaled .99% for 2013 year to date compared to .71% for 2012 and 4.11% in 2011. Annualized net charge-offs for 2013 were driven by charging off the specific reserves on two large commercial real estate relationships.Non-performing loans were $21.5 million or 4.52% of total loans at September 30, 2013 compared to $31.7 million, or 5.53% of total loans for September 30, 2012.The allowance for loan losses to non-performing loans, which excludes restructured loans on accrual status, was 57% at September 30, 2013 compared to 58% at September 30, 2012.

The net interest margin improved to 2.83% for the nine months ended September 30, 2013 compared to 2.55% for the year ended December 31, 2012 and 2.53% for the nine months ended September 30, 2012.The main driver to the improvement in the net interest margin for 2013 compared to 2012 is the intentional decrease of $186.5 million in average certificates of deposits that resulted in a reduction of $4.1 in related interest expense during the period.We continue to anticipate modest improvement to the net interest margin over the next several quarters, as we continue to focus on restructuring the balance sheet to decrease our cost of funds, improve interest income, and reduce our interest rate risk exposure.However, the balance sheet restructuring may be impacted by the acceleration of loan repayments.Low interest rates, coupled with a competitive lending environment, continue to prove to be challenging.

REGULATORY MATTERS

Since January 2011, the Bank has operated under Consent Orders with the FDIC and KDFI. In the most recent Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012.The Bank also agreed that if it should be unable to reach the required capital levels by that date, and if directed in writing by the FDIC, then within 30 days the Bank would develop, adopt and implement a written plan to sell or merge itself into another federally insured financial institution.To date the Bank has not received such a written direction.The Consent Order also prohibits the Bank from declaring dividends without the prior written approval of the FDIC and KDFI and requires the Bank to develop and implement plans to reduce its level of non-performing assets and concentrations of credit in commercial real estate loans, maintain adequate reserves for loan and lease losses, implement procedures to ensure compliance with applicable laws, and take certain other actions. A copy of the most recent Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.

At September 30, 2013, the Bank’s Tier 1 capital ratio was 7.80% and the total risk-based capital ratio was 13.09%, compared to the minimum 9.00% and 12.00% capital ratios required by the Consent Order.For the fourth consecutive quarter, we have achieved and maintained the total risk-based capital ratio but have yet to achieve the Tier 1 capital ratio. We are continuing to explore our strategic alternatives to achieve and maintain the Tier 1 capital ratio as well as to comply with all of the other terms of the consent order.

The Consent Order requires us to obtain the consent of the FDIC and the KDFI in order for the Bank to pay cash dividends to the Corporation.In addition, due to the Bank’s designation as a “troubled institution,” the Bank cannot accept, renew or rollover brokered deposits, and is restricted in the amount of interest can pay on deposits.

On April 20, 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends and to take steps to ensure the Bank complies with the Consent Order.We also may not redeem shares or obtain additional borrowings without prior approval.

Bank regulatory agencies have discretion when an institution does not meet the terms of a consent order.The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business.

Management and the Board of Directors have been actively engaged with our investment banking firm in reviewing all of the strategic alternatives.One of these alternatives was to sell branches that were located outside of our core market.On July 6, 2012, we sold our four banking centers in Southern Indiana, receiving a 3.65% premium on the $102.3 million of consumer and commercial deposits at closing.The buyer assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received no premium or discount.We also sold approximately $30.4 million in performing loans at a discount of 0.80%.Other assets sold included vault cash of $367,000 and fixed assets of $887,000.The Indiana branch sale resulted in a gain of $3.1 million.

38

Our plans for the remainder of 2013 include the following:

· Continuing to identify and evaluate available strategic options to meet regulatory capital levels and all other requirements of our Consent Order.

· Continuing to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner.

· Continuing to reduce expenses and improve our ability to operate in a profitable manner.

· Continuing to reduce our lending concentration in commercial real estate through expected maturities and repayments.We have implemented loan diversification initiatives in place that we believe should improve the loan portfolio.Increased emphasis on retail lending, small business lending and Small Business Administration (“SBA”) lending are all expected to boost non-interest fee income.We have already reallocated resources that that we believe should contribute to the successful execution of all of these efforts.Our mortgage and consumer lending operations have maintained strong credit quality metrics throughout the economic downturn.

· Enhancing our resources dedicated to special asset dispositions, both on a permanent and temporary basis, to accelerate our efforts to dispose of problem assets.Our objective is reduce the involvement of our commercial lenders in the special asset area, allowing them to shift their focus to their existing loan customer base and generate new business that supports our diversification efforts while stemming some of the loan roll-off.

· Continuing to reduce our inventory of other real estate owned properties. 

While our concerns about economic conditions in our market continue, we are working towards our long-range objectives including building additional core customer relationships, maintaining sufficient liquidity and capital levels, improving shareholder value, remediating our problem assets and building upon the sustained success of our retail franchise.

CRITICAL ACCOUNTING POLICIES

Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry.The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could change as our estimates, assumptions, and judgments change.Certain policies inherently rely more heavily on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported.We consider our critical accounting policies to include the following:

Allowance for Loan Losses – We maintain an allowance we believe to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. Our Appraisal Review Committee, which is comprised of senior officers and certain accounting associates, evaluates the allowance for loan losses on a monthly basis. We estimate the amount of the allowance using past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of the underlying collateral, and current economic conditions. While we estimate the allowance for loan losses based in part on historical losses within each loan category, estimates for losses within the commercial real estate portfolio depend more on credit analysis and recent payment performance. Allocations of the allowance may be made for specific loans or loan categories, but the entire allowance is available for any loan that, in management’s judgment, should be charged off. 

The allowance consists of specific and general components.The specific component relates to loans that are individually classified as impaired.The general component covers non-impaired loans and is based on historical loss experience for certain categories adjusted for current factors. Allowance estimates are developed with actual loss experience adjusted for current economic conditions.Allowance estimates are considered a prudent measurement of the risk in the loan portfolio and are applied to individual loans based on loan type.

39

Based on our calculation, an allowance of $12.2 million or 2.57% of total loans was our estimate of probable incurred losses within the loan portfolio as of September 30, 2013. As a consequence of this estimate we recorded a net reversal of provision for loan losses on the income statement of $1.3 million for the 2013 period. If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could materially increase.

Impairment of Investment Securities – We review all unrealized losses on our investment securities to determine whether the losses are other-than-temporary.We evaluate our investment securities on at least a quarterly basis, and more frequently when economic or market conditions warrant, to determine whether a decline in their value below amortized cost is other-than-temporary.We evaluate a number of factors including, but not limited to: valuation estimates provided by investment brokers; how much fair value has declined below amortized cost; how long the decline in fair value has existed; the financial condition of the issuer; significant rating agency changes on the issuer; and management’s assessment that we do not intend to sell or will not be required to sell the security for a period of time sufficient to allow for any anticipated recovery in fair value.

The term “other-than-temporary” is not intended to indicate that the decline is permanent, but indicates that the possibility for a near-term recovery of value is not necessarily favorable, or that there is a lack of evidence to support a realizable value equal to or greater than the carrying value of the investment.Once a decline in value is determined to be other-than-temporary, the cost basis of the security is written down to fair value and a charge to earnings is recognized for the credit component and the non-credit component is recorded to other comprehensive income.

Real Estate Owned – The estimation of fair value is significant to real estate owned-acquired through foreclosure.These assets are recorded at fair value less estimated selling costs at the date of foreclosure.Fair value is based on the appraised market value of the property based on sales of similar assets when available.The value may be subsequently reduced if the estimated fair value declines below the value recorded at the time of foreclosure.Appraisals are performed at least annually, if not more frequently.Typically, appraised values are discounted for the projected sale below appraised value in addition to the selling cost.With certain appraised values where management believes a solid liquidation value has been established, the appraisal has been discounted only by the selling cost.We have dedicated a team of associates and management focused on the continued resolution and work out of OREO.Appropriate policies, committees and procedures have been put in place to ensure the proper accounting treatment and risk management of this area.

Income Taxes – The provision for income taxes is based on income/(loss) as reported in the financial statements.Deferred income tax assets and liabilities are computed for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future.The deferred tax assets and liabilities are computed based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income.An assessment is made as to whether it is more likely than not that deferred tax assets will be realized.A valuation allowance is established when necessary to reduce deferred tax assets to an amount more likely than not expected to be realized.Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities.Tax credits are recorded as a reduction to the tax provision in the period for which the credits may be utilized.

A full valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized.In assessing the need for a full valuation allowance, we considered various factors including our four year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and operating results in 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order.Based on this assessment, we concluded that a valuation allowance was necessary at September 30, 2013 and December 31, 2012.

RESULTS OF OPERATIONS

Net income attributable to common shareholders for the quarter ended September 30, 2013 was $1.2 million or $0.25 per diluted common share compared to a net loss attributable to common shareholders of $1.0 million or $0.21 per diluted common share for the same period in 2012.Net loss attributable to common shareholders for the nine months ended September 30, 2013 was $328,000 or $0.07 per diluted common share compared to a net loss attributable to common shareholders of $6.0 million or $1.25 per diluted common share for the same period a year ago.The main drivers to the net loss for 2013 include the following:

· declining net interest income mainly driven by a decline of $7.2 million in loan interest income as a result of a decline of $156.7 million in average loan balances combined with the continuing low interest rate environment;

· a decrease in net gains of $2.5 million on the sale of securities available for sale; and

40

· a decline of $450,000 in securities interest income mainly due to the continued low interest rate environment.

These factors were partially offset by the following:

· a $5.9 million decrease in provision for loans losses due to the improvement in specific reserves allocated to several relationships based upon improved credit quality;

· a decline of $4.9 million in deposit interest expense mainly as a result of an intentional decrease of $186.5 million in average certificates of deposits and other time deposits balances combined with a decline of 41 basis points in the cost of these deposits;

· a $3.2 million decrease in write downs and sale losses on other real estate owned (“OREO”),

· a $2.7 million decrease in real estate acquired through foreclosure expense and loan expense, the result of lower loan workout and loan portfolio management expenses as our level of non-performing assets has decreased, and

· a $596,000 increase in gains recorded on the sale of OREO.

Net loss attributable to common shareholders was also increased by the accrual for unpaid dividends on preferred shares.Our book value per common share decreased from $5.88 at September 30, 2012 to $2.99 at September 30, 2013 largely as a result of unrealized losses on available-for-sale securities driven by increased market rates, compared to unrealized gains in 2012.

Net Interest Income – The largest component of our net income is our net interest income.Net interest income is the difference between interest income, principally from loans and investment securities, and interest expense, principally on customer deposits and borrowings. Changes in net interest income result from changes in volume, net interest spread and net interest margin. Volume refers to the average dollar levels of interest-earning assets and interest-bearing liabilities. Net interest spread refers to the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities. Net interest margin refers to net interest income divided by average interest-earning assets and is influenced by the level and relative mix of interest-earning assets and interest-bearing liabilities.

The majority of our assets are interest-earning and our liabilities are interest-bearing. Accordingly, changes in interest rates may impact our net interest margin. The Federal Open Markets Committee (“FOMC”) uses the federal funds rate, which is the interest rate used by banks to lend to each other, to influence interest rates and the national economy. Changes in the federal funds rate have a direct correlation to changes in the prime rate, the underlying index for most of the variable-rate loans we issue. The FOMC has held the target federal funds rate at a range of 0-25 basis points since December 2008. As we are asset sensitive, continued low rates will negatively impact our earnings and net interest margin.

The large decline in the volume of interest earning assets and the change in the mix of interest earning assets reduced net interest income by $206,000 and $2.3 million for the three and nine month 2013 periods compared to the prior year periods.Average interest earning assets decreased $171.3 million and 224.2 million for the quarter and nine month 2013 periods compared to 2012 primarily driven by a decrease in average loans.The decrease in average loans was due to loans sold in connection with the branch sale during the third quarter of 2012, loan principal payments, payoffs, charge-offs and the conversion of nonperforming loans to OREO properties.In addition, due to the higher regulatory capital ratios required by our consent order, we elected not to replace much of this loan run-off in accordance with our efforts to reduce our level of assets and risk-weighted assets. The average loan yield was 5.12% and 5.24% for the three and nine month 2013 periods compared to an average loan yield of 5.43% and 5.45% for the 2012 periods.

Average interest bearing liabilities decreased $175.5 million and $229.8 million for the quarter and nine month 2013 periods compared to 2012 driven by a decrease in average certificates of deposit and NOW and money market accounts.The decrease in average deposits was due to the sale of deposits included in the branch sale during the third quarter of 2012 and an intentional decrease in certificates of deposit as we focus on restructuring the balance sheet to decrease our cost of funds and improve net interest income. 

The tax equivalent yield on earning assets averaged 3.95% and 3.90% for the three and nine month 2013 periods compared to 3.98% and 4.04% for 2012.The change in the yields on interest earning assets were partially offset by a decrease in our cost of funds, which averaged 1.08% and 1.16% for the three and nine month 2013 periods compared to an average cost of funds of 1.54%and 1.60% for the same periods in 2012.Net interest margin as a percent of average earning assets increased 42 basis points to 2.96% for the quarter ended September 30, 2013 and increased 30 basis points to 2.83% for the nine months ended September 30, 2013 compared to 2.54% and 2.53% for the 2012 periods.We anticipate being able to continue taking advantage of the continued low interest rate environment to reduce our cost of funds, as term deposits re-price at more favorable terms.

41

AVERAGE BALANCE SHEET

The following table provides information relating to our average balance sheet and reflects the average yield on assets and average cost of liabilities for the indicated periods.Yields and costs for the periods presented are derived by dividing income or expense by the average balances of assets or liabilities, respectively.

	Quarter Ended September 30,
	2013						2012
	Average				Average		Average				Average
(Dollars in thousands)	Balance		Interest		Yield/Cost (5)		Balance		Interest		Yield/Cost (5)
ASSETS
Interest earning assets:
U.S. Government and federal agency	$	-	$	-	-	%	$	13,174	$	63	1.90	%
Mortgage-backed securities		235,530		1,173	1.98	%		280,664		1,328	1.88	%
State and political subdivision securities (1)		14,251		188	5.23	%		13,529		242	7.10	%
Trust Preferred Securities		-		-	-	%		1,040		9	3.43	%
Corporate bonds		56,013		400	2.83	%		14,109		84	2.36	%
Loans (2) (3) (4)		488,494		6,308	5.12	%		590,418		8,082	5.43	%
FHLB stock		4,430		47	4.21	%		4,805		49	4.05	%
Interest bearing deposits		17,150		9	0.21	%		69,444		47	0.27	%
Total interest earning assets		815,868		8,125	3.95	%		987,183		9,904	3.98	%
Less: Allowance for loan losses		(15,871)						(16,507)
Non-interest earning assets		74,394						90,665
Total assets	$	874,391					$	1,061,341
LIABILITIES AND STOCKHOLDERS' EQUITY
Interest bearing liabilities:
Savings accounts	$	89,356	$	40	0.18	%	$	83,542	$	66	0.31	%
NOW and money market accounts		243,533		82	0.13	%		280,913		317	0.45	%
Certificates of deposit and other time deposits		365,675		1,439	1.56	%		521,093		2,569	1.96	%
FHLB advances		32,750		133	1.61	%		21,300		216	4.02	%
Subordinated debentures		18,000		340	7.49	%		18,000		421	9.28	%
Total interest bearing liabilities		749,314		2,034	1.08	%		924,848		3,589	1.54	%
Non-interest bearing liabilities:
Non-interest bearing deposits		80,523						79,266
Other liabilities		11,759						8,467
Total liabilities		841,596						1,012,581
Stockholders' equity		32,795						48,760
Total liabilities and
stockholders' equity	$	874,391					$	1,061,341
Net interest income			$	6,091					$	6,315
Net interest spread					2.87	%					2.44	%
Net interest margin					2.96	%					2.54	%

(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.

(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.

(3) Calculations include non-accruing loans in the average loan amounts outstanding.

(4) Includes loans held for sale.

(5) Annualized

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	Nine Months Ended September 30,
	2013						2012
	Average				Average		Average				Average
(Dollars in thousands)	Balance		Interest		Yield/Cost (5)		Balance		Interest		Yield/Cost (5)
ASSETS
Interest earning assets:
U.S. Government and federal agency	$	2,548	$	28	1.47	%	$	18,749	$	293	2.09	%
Mortgage-backed securities		256,138		3,414	1.78	%		290,143		4,297	1.98	%
State and political subdivision securities (1)		14,803		609	5.50	%		15,600		783	6.71	%
Trust Preferred Securities		-		-	-	%		1,050		38	4.84	%
Corporate bonds		52,579		1,051	2.67	%		4,840		85	2.35	%
Loans (2) (3) (4)		503,227		19,729	5.24	%		659,961		26,911	5.45	%
FHLB stock		4,513		145	4.30	%		4,805		152	4.23	%
Interest bearing deposits		24,184		43	0.24	%		87,051		151	0.23	%
Total interest earning assets		857,992		25,019	3.90	%		1,082,199		32,710	4.04	%
Less: Allowance for loan losses		(16,348)						(17,415)
Non-interest earning assets		78,918						92,218
Total assets	$	920,562					$	1,157,002
LIABILITIES AND
STOCKHOLDERS' EQUITY
Interest bearing liabilities:
Savings accounts	$	89,083	$	147	0.22	%	$	92,174	$	209	0.30	%
NOW and money market accounts		262,660		437	0.22	%		296,952		1,155	0.52	%
Certificates of deposit and other time deposits		401,583		4,887	1.63	%		588,119		8,977	2.04	%
FHLB advances		19,695		397	2.70	%		25,607		783	4.09	%
Subordinated debentures		18,000		1,022	7.59	%		18,000		1,103	8.19	%
Total interest bearing liabilities		791,021		6,890	1.16	%		1,020,852		12,227	1.60	%
Non-interest bearing liabilities:
Non-interest bearing deposits		79,836						79,230
Other liabilities		11,071						6,061
Total liabilities		881,928						1,106,143
Stockholders' equity		38,634						50,859
Total liabilities and
stockholders' equity	$	920,562					$	1,157,002
Net interest income			$	18,129					$	20,483
Net interest spread					2.74	%					2.44	%
Net interest margin					2.83	%					2.53	%

(1) Taxable equivalent yields are calculated assuming a 34% federal income tax rate.

(2) Includes loan fees, immaterial in amount, in both interest income and the calculation of yield on loans.

(3) Calculations include non-accruing loans in the average loan amounts outstanding.

(4) Includes loans held for sale.

(5) Annualized

43

 

RATE/VOLUME ANALYSIS

The table below shows changes in interest income and interest expense for the periods indicated.For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in rate (changes in rate multiplied by old volume); (2) changes in volume (change in volume multiplied by old rate); and (3) changes in rate-volume (change in rate multiplied by change in volume).Changes in rate-volume are proportionately allocated between rate and volume variance.

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013 vs. 2012						2013 vs. 2012
	Increase (decrease)						Increase (decrease)
	Due to change in						Due to change in
						Net						Net
(Dollars in thousands)	Rate		Volume		Change		Rate		Volume		Change
Interest income:
U.S. Treasury and agencies	$	(47)	$	(16)	$	(63)	$	(68)	$	(197)	$	(265)
Mortgage-backed securities		67		(222)		(155)		(407)		(476)		(883)
State and political subdivision     securities		(66)		12		(54)		(136)		(38)		(174)
Trust preferred securities		(7)		(2)		(9)		(10)		(28)		(38)
Corporate bonds		20		296		316		13		953		966
Loans		(438)		(1,336)		(1,774)		(1,003)		(6,179)		(7,182)
FHLB stock		2		(4)		(2)		3		(10)		(7)
Interest bearing deposits		(9)		(29)		(38)		3		(111)		(108)
Total interest earning assets		(478)		(1,301)		(1,779)		(1,605)		(6,086)		(7,691)
Interest expense:
Savings accounts		(30)		4		(26)		(55)		(7)		(62)
NOW and money market accounts		(197)		(38)		(235)		(598)		(120)		(718)
Certificates of deposit and other     time deposits		(456)		(674)		(1,130)		(1,595)		(2,495)		(4,090)
FHLB advances		(166)		83		(83)		(230)		(156)		(386)
Subordinated debentures		(81)		-		(81)		(81)		-		(81)
Total interest bearing liabilities		(930)		(625)		(1,555)		(2,559)		(2,778)		(5,337)
				��
Net change in net interest income	$	452	$	(676)	$	(224)	$	954	$	(3,308)	$	(2,354)

Non-Interest Income and Non-Interest Expense

The following tables compare the components of non-interest income and expenses for the periods ended September 30, 2013 and 2012.The tables show the dollar and percentage change from 2012 to 2013.Below each table is a discussion of significant changes and trends.

	Three Months Ended
	September 30,
(Dollars in thousands)	2013		2012		Change		%
Non-interest income
Customer service fees on deposit accounts	$	1,444	$	1,339	$	105	7.8	%
Gain on sale of mortgage loans		230		505		(275)	-54.5	%
Gain on sale of investments		235		2,054		(1,819)	-88.6	%
Loss on sale and calls of investments		(223)		(350)		127	-36.3	%
Loss on sale and write downs of real     estate acquired through     foreclosure		(365)		(1,587)		1,222	-77.0	%
Gain on branch divestiture		-		3,124		(3,124)	-100.0	%
Gain on sale on real estate acquired through foreclosure		1,632		630		1,002	159.0	%
Brokerage commissions		127		109		18	16.5	%
Other income		466		632		(166)	-26.3	%
	$	3,546	$	6,456	$	(2,910)	-45.1	%

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	Nine Months Ended
	September 30,
(Dollars in thousands)	2013		2012		Change		%
Non-interest income
Customer service fees on deposit accounts	$	3,942	$	4,121	$	(179)		-4.3	%
Gain on sale of mortgage loans		818		1,200		(382)		-31.8	%
Gain on sale of investments		1,078		3,363		(2,285)		-67.9	%
Loss on sale and calls of investments		(839)		(653)		(186)		28.5	%
Net impairment losses recognized in earnings		-		(26)		26		-100.0	%
Loss on sale and write downs of real     estate acquired through     foreclosure		(1,957)		(5,169)		3,212		-62.1	%
Gain on branch divestiture		-		3,124		(3,124)		-100.0	%
Gain on sale of premises and equipment		-		322		(322)		-100.0	%
Gain on sale on real estate acquired through foreclosure		1,839		1,243		596		47.9	%
Gain on sale of real estate held for development		-		175		(175)		-100.0	%
Brokerage commissions		384		316		68		21.5	%
Other income		1,421		1,660		(239)		-14.4	%
	$	6,686	$	9,676	$	(2,990)		-30.9	%

We originate qualified Veterans Affairs (VA), Kentucky Housing Corporation (KHC), Rural Housing Corporation (RHC) and conventional secondary market loans and sell them into the secondary market with servicing rights released.Gain on sale of mortgage loans decreased for 2013 due to a decrease in the volume and the yield earned on loans refinanced, originated and sold compared to 2012.

We invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, mutual funds, stocks and others.During 2013 we recorded a net gain on the sale of debt investment securities of $239,000 compared to a net gain on sale of debt investment securities of $2.7 million for the 2012 period.

We recognized other-than-temporary impairment charges of $26,000 for the expected credit loss during the 2012 period on one of our trust preferred securities. The 2012 impairment charge was related to Preferred Term Security VI which was called for early redemption in July 2012.Management believes this impairment was primarily attributable to the current economic environment in which the financial condition of some of the issuers deteriorated.

Non-interest income for 2013 was reduced by $2.0 million in losses on the sale and write down of real estate owned properties due to the decline in market value of properties held in this portfolio. Offsetting the losses and write downs were recorded gains of $1.8 million on the sale of fourteen real estate owned properties.

During the third quarter of 2012, we successfully sold four banking centers located in Corydon, Elizabeth, Lanesville and Georgetown, Indiana.The transaction resulted in a gain of $3.1 million.

During the second quarter of 2012 we recorded $175,000 in gains from the sale of the last of nine lots we held for sale in an office park adjacent to our home office.We also recorded a gain of $322,000 on the sale of two properties held by the Bank as possible new banking center locations in Clarksville, Indiana and Elizabethtown, Kentucky.

The decrease in other income for the 2013 period was the result of decreases in income received on real estate owned properties.

	Three Months Ended
	September 30,
(Dollars in thousands)	2013		2012		Change		%
Non-interest expenses
Employee compensation and benefits	$	3,955	$	3,609	$	346		9.6	%
Office occupancy expense and equipment		653		777		(124)		-16.0	%
Marketing and advertising		99		113		(14)		-12.4	%
Outside services and data processing		900		853		47		5.5	%
Bank franchise tax		315		402		(87)		-21.6	%
FDIC insurance premiums		460		663		(203)		-30.6	%
Real estate acquired through foreclosure expense		452		638		(186)		-29.2	%
Loan expense		485		568		(83)		-14.6	%
FHLB advance prepayment penalty		-		1,548		(1,548)		-100.0	%
Other expense		1,286		1,682		(396)		-23.5	%
	$	8,605	$	10,853	$	(2,248)		-20.7	%

45

	Nine Months Ended
	September 30,
(Dollars in thousands)	2013		2012		Change		%
Non-interest expenses
Employee compensation and benefits	$	11,505	$	11,284	$	221	2.0	%
Office occupancy expense and equipment		2,051		2,327		(276)	-11.9	%
Marketing and advertising		273		281		(8)	-2.8	%
Outside services and data processing		2,704		2,557		147	5.7	%
Bank franchise tax		708		1,146		(438)	-38.2	%
FDIC insurance premiums		1,654		1,760		(106)	-6.0	%
Amortization of intangible assets		-		127		(127)	-100.0	%
Real estate acquired through foreclosure expense		1,270		3,314		(2,044)	-61.7	%
Loan expense		1,092		1,732		(640)	-37.0	%
FHLB advance prepayment penalty		-		1,548		(1,548)	-100.0	%
Other expense		4,211		4,482		(271)	-6.0	%
	$	25,468	$	30,558	$	(5,090)	-16.7	%

Bank franchise tax is paid to the commonwealth of Kentucky and represents taxes paid based on capital. Bank franchise expense decreased during 2013 compared to 2012 primarily due to a decrease in our capital for the period.

FDIC insurance premiums are based on the FDIC’s assessment base and rate structure. The assessment base is defined as the average consolidated total assets less average Tier I Capital.As a result of the decrease in total assets for 2013, FDIC insurance premiums have subsequently been reduced. FDIC insurance premiums are comparable for the nine month 2013 period when compared to the same period in 2012 due to a $132,000 assessment recorded during the first quarter of 2013 based on an increase to our FDIC risk category profile.

Amortization of intangible assets decreased due to the sale of our four Indiana banking centers in 2012 in which the related intangible assets were fully amortized.

Real estate acquired through foreclosure expense and loan expense decreased due to a reduction in loan workout and loan portfolio management expenses due to a lower level of non-performing assets. Real estate acquired through foreclosure expense was also higher in 2012 due to a $1.5 million termination fee paidthat was related to the termination of a property investment and management agreement on a residential development held in other real estate owned. 

During the third quarter of 2012, we prepaid a $10.0 million convertible fixed rate advance with an interest rate of 3.99% and a scheduled maturity date of 2014.We also prepaid a $5.0 million convertible fixed rate advance with an interest rate of 4.22% and a scheduled date of 2017.In connection with these transactions, we incurred $1.5 million in prepayment penalties.We prepaid these advances to decrease our cost of funds and improve net interest income.

The decrease in other expense for the 2013 periods relates to decreases in the amortization of our low income housing tax investments.

Income Taxes

The provision for income taxes includes federal and state income taxes and in 2013 and 2012 reflects a full valuation allowance against all of our deferred tax assets. The effective tax rate for the quarter and nine month periods ended September 30, 2013 and 2012 is not meaningful due to the reduction of income tax benefit as the result of maintaining a full deferred tax valuation allowance.Historically, the fluctuations in effective tax rates reflect the effect of permanent differences in the inclusion or deductibility of certain income and expenses, respectively, for income tax purposes.

A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized.In assessing the need for a valuation allowance, we considered all positive and negative evidence including our four year cumulative loss position, the level of our non-performing assets, our inability to meet our forecasted levels of assets and operating results in 2013, 2012 and 2011 and our non-compliance with the capital requirements of our Consent Order.Based on this assessment, we concluded that a valuation allowance was necessary at September 30, 2013 and December 31, 2012.Our future effective income tax rate will fluctuate based on the mix of taxable and tax free investments we make and, to a greater extent, the impact of changes in the required amount of valuation allowance recorded against our net deferred tax assets and our overall level of taxable income.

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Recording a valuation allowance does not have any impact on our liquidity, nor does it preclude us from using the tax losses, tax credits or other timing differences in the future.To the extent that we generate taxable income in a given quarter, the valuation allowance may be reduced to fully or partially offset the corresponding income tax expense.Any remaining deferred tax asset valuation allowance may be reversed through income tax expense once we can demonstrate a sustainable return to profitability and conclude that it is more likely than not the deferred tax asset will be utilized prior to expiration.

ANALYSIS OF FINANCIAL CONDITION

Total assets at September 30, 2013 decreased $156.9 million compared to total assets at December 31, 2012.The decrease was primarily attributable to a decline of $63.9 million in available-for-sale securities, a decline of $48.8 million in total loans, a $31.6 million decline in cash and cash equivalents and a decline in real estate acquired through foreclosure of $13.4 million. Total deposits decreased $175.7 million due to an intentional decrease in certificates of deposit as we focus on restructuring the balance sheet to decrease our cost of funds and improve net interest income.

Loans

Total loans decreased $48.8 million to $476.1 million at September 30, 2013 compared to $524.9 million at December 31, 2012. Our commercial real estate portfolio decreased $33.4 million to $287.5 million at September 30, 2013.Our residential mortgage loan, consumer and home equity and indirect consumer portfolios also decreased for the 2013 period.The decline in the total loan portfolio is a primarily the result of pay-offs, charge-offs, and loans being transferred to real estate acquired through foreclosure for commercial real estate loans.Charge-offs made up $4.1 million or 8.3% of this decrease.The decline in the loan portfolio was also due, in part, to our ongoing efforts to resolve problem loans.In addition, we have elected not to replace much of this loan run-off in order to reduce asset size and increase capital in light of the higher regulatory capital ratios imposed by our consent order.

	September 30,		December 31,
(Dollars in thousands)	2013		2012
Commercial Real Estate (CRE):
Other-CRE other than Land
Development and Building Lots	$	263,509	$	290,424
Land Development		22,395		28,310
Building Lots		1,599		2,151
Residential mortgage		101,281		110,025
Consumer and home equity		53,988		57,888
Commercial		20,394		19,931
Indirect consumer		12,938		16,211
		476,104		524,940
Less:
Net deferred loan origination fees		(73)		(105)
Allowance for loan losses		(12,224)		(17,265)
		(12,297)		(17,370)
Net Loans	$	463,807	$	507,570

Allowance and Provision for Loan Losses

Our financial performance depends on the quality of the loans we originate and management’s ability to assess the degree of risk in existing loans when it determines the allowance for loan losses.An increase in loan charge-offs or non-performing loans or an inadequate allowance for loan losses could reduce net interest income, net income and capital, and limit the range of products and services we can offer.

The Appraisal Review Committee evaluates the allowance for loan losses monthly to maintain a level it believes to be sufficient to absorb probable incurred credit losses existing in the loan portfolio.Periodic provisions to the allowance are made as needed.The Committee determines the allowance by applying loss estimates to graded loans by categories, as described below.When appropriate, a specific reserve will be established for individual impaired loans based upon the risk classification and the estimated potential for loss.In accordance with our credit management processes, we obtain new appraisals on properties securing our non-performing commercial and commercial real estate loans and use those appraisals to determine specific reserves within the allowance for loan losses.As we receive new appraisals on properties securing non-performing loans, we recognize charge-offs and adjust specific reserves as appropriate.In addition, the Committee analyzes such factors as changes in lending policies and procedures; real estate market conditions; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.

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Declines in collateral values, including commercial real estate, may impact our ability to collect on certain loans when borrowers are dependent on the values of the real estate as a source of cash flow.While we anticipate that challenges will continue in the foreseeable future as we manage the overall level of our credit quality, we believe that credit quality appears to be stabilizing as compared to the significant changes observed in real estate values prior to 2012.As a result of the relative stabilization in real estate values during 2012 and 2013, our provision for loan losses decreased.

As discussed in the Overview to this section, we have entered into a Consent Order with bank regulatory agencies.In addition to increasing capital ratios, we agreed to maintain adequate reserves for loan losses, develop and implement plans to reduce the level of non-performing assets and concentrations of credit in commercial real estate loans, implement revised credit risk management practices and credit administration policies and procedures, and report our progress to the regulators.

The following table analyzes our loan loss experience for the periods indicated. 

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(Dollars in thousands)	2013			2012			2013			2012
Balance at beginning of period	$	15,947		$	15,300		$	17,265		$	17,181
Loans charged-off:
Residential mortgage		73			-			73			62
Consumer & home equity		156			110			311			386
Commercial & commercial real estate		3,124			361			3,670			3,351
Total charge-offs		3,353			471			4,054			3,799
Recoveries:
Residential mortgage		13			-			17			1
Consumer & home equity		44			59			134			145
Commercial & commercial real estate		73			64			187			166
Total recoveries		130			123			338			312
Net loans charged-off		3,223			348			3,716			3,487
Provision for loan losses		(500)			2,671			(1,325)			4,598
Balance at end of period		12,224			17,623			12,224			18,292
Less: Allowance allocated to loans held for           sale in probable branch divestiture		-			201			-			(468)
Balance at end of period, net	$	12,224		$	17,824		$	12,224		$	17,824
Allowance for loan losses to total loans (1) (2)		2.57	%		3.19	%		2.57	%		3.19	%
Annualized net charge-offs to average     loans outstanding		2.62	%		0.23	%		0.99	%		0.71	%
Allowance for loan losses to     total non-performing loans (2)		57	%		58	%		57	%		58	%

(1)	Includes loans held for sale in probable branch divestiture and probable loan sale for 2012
(2)	Includes allowance allocated to loans held for sale in probable branch divestiture for 2012

Provision for loan losses decreased $3.2 million for the three months ended September 30, 2013 compared to the same three month period in 2012.Provision for loan losses decreased $5.9 million for the nine months ended September 30, 2013 compared to the same nine month period in 2012.We recorded a reversal of provision expense for 2013 due to a decline in the loan portfolio, a lower level of classified loans when compared to 2012 and an improvement in the specific reserves allocated to several relationships based upon improved credit quality.

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The allowance for loan losses was $12.2 million at September 30, 2013, a decrease of $5.6 million compared to 2012. The decrease was driven by a reversal of provision expense and net charge-offs of $3.7 million taken during the nine month period, including specific reserves of $3.6 million charged off on our collateral dependent loans of which $4.8 million had been reserved for at December 31, 2012.The allowance for loan losses as a percent of total loans was 2.57% for September 30, 2013 compared to 3.19% at September 30, 2012.The allowance for loan losses as a percent of total impaired loans was 57% for September 30, 2013 compared to 58% at September 30, 2012.Specific reserves allocated to substandard loans made up 32% of the total allowance for loan loss at September 30, 2013 compared to 49% at September 30, 2012.Net charge-offs for the 2013 period included $3.4 million in partial charge-offs compared to partial charge-offs of $1.5 million at September 30, 2012.

Federal regulations require banks to classify their own assets on a regular basis.The regulations provide for three categories of classified loans — substandard, doubtful and loss.In addition, we also classify loans as criticized.Loans classified as criticized have a potential weakness that deserves management’s close attention.

The following table provides information with respect to criticized and classified loans as of the dates indicated:

	September 30,		June 30,		March 31,		December 31,		September 30,
(Dollars in thousands)	2013		2013		2013		2012		2012
Criticized Loans:
Total Criticized	$	22,456	$	27,892	$	27,068	$	24,869	$	25,141
Classified Loans:
Substandard	$	45,798	$	41,256	$	42,043	$	50,320	$	65,542
Doubtful		-		-		-		-		-
Loss		-		-		-		-		-
Total Classified	$	45,798	$	41,256	$	42,043	$	50,320	$	65,542
Total Criticized and Classified	$	68,254	$	69,148	$	69,111	$	75,189	$	90,683

Total criticized and classified loans declined by $6.9 million or 9% from December 31, 2012 and by $22.4 million or 25% from September 30, 2012.The increase in classified loans for the third quarter of 2013 as compared to the second quarter of 2013 was due to the downgrading of a commercial real estate relationship totaling $4.8 million from criticized status to substandard.Approximately $40.7 million or 89% of the total classified loans at September 30, 2013 were related to commercial real estate loans in our market area.Classified consumer loans totaled $761,000, classified mortgage loans totaled $3.0 million and classified commercial loans totaled $1.4 million.Our decision to record a reversal of a portion of the allowance for loan losses during 2013 resulted from the application of a consistent allowance methodology that is driven by risk ratings.For more information on collection efforts, evaluation of collateral and how loss amounts are estimated, see “Non-Performing Assets,” below. 

Although we may allocate a portion of the allowance to specific loans or loan categories, the entire allowance is available for charge-offs.We develop our allowance estimates based on actual loss experience adjusted for current economic conditions.Allowance estimates represent a prudent measurement of the risk in the loan portfolio, which we apply to individual loans based on loan type.If economic conditions continue to put stress on our borrowers going forward, this may require higher provisions for loan losses in future periods.We have allocated additional resources to address credit quality and facilitate the structure and processes to diversify and strengthen our lending function.Credit quality will continue to be a primary focus for the remainder of 2013 and going forward.

Non-Performing Assets

Non-performing assets consist of certain non-accruing restructured loans for which the interest rate or other terms have been renegotiated, loans on which interest is no longer accrued, real estate acquired through foreclosure and repossessed assets.We do not have any loans longer than 90 days past due still on accrual at June 30, 2013.Loans, including impaired loans, are placed on non-accrual status when they become past due 90 days or more as to principal or interest, unless they are adequately secured and in the process of collection.Loans are considered impaired when we no longer anticipate full principal or interest will be paid in accordance with the contractual loan terms.If a loan is impaired, we allocate a portion of the allowance so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate, or at the fair value of collateral if repayment is expected solely from collateral.

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Non-accrual loans that have been restructured remain on non-accrual status until we determine the future collection of principal and interest is reasonably assured, which will require that the borrower demonstrate a period of performance in accordance to the restructured terms of six months or more. Accruing loans that have been restructured are evaluated for non-accrual status based on a current evaluation of the borrower’s financial condition and ability and willingness to service the modified debt.

We review our loans on a regular basis and implement normal collection procedures when a borrower fails to make a required payment on a loan.If the delinquency on a mortgage loan exceeds 90 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action.We generally charge off consumer loans when management deems a loan uncollectible and any available collateral has been liquidated.We handle commercial business and real estate loan delinquencies on an individual basis.These loans are placed on non-accrual status upon becoming contractually past due 90 days or more as to principal and interest or where substantial doubt about full repayment of principal and interest is evident.

We recognize interest income on loans on the accrual basis except for those loans in a non-accrual of income status. We discontinue accruing interest on impaired loans when management believes, after consideration of economic and business conditions and collection efforts, that the borrowers’ financial condition is such that collection of interest is doubtful, typically after the loan becomes 90 days delinquent.When we discontinue interest accrual, we reverse existing accrued interest and subsequently recognize interest income only to the extent we receive cash payments and are assured of repayment of all outstanding principal.

We require appraisals and perform evaluations on impaired assets upon initial identification. Thereafter, we obtain appraisals or perform market value evaluations on impaired assets at least annually. Recognizing the volatility of certain assets, we assess the transaction and market conditions to determine if updated appraisals are needed more frequently than annually.Additionally, we evaluate the collateral condition and value in the event of foreclosure.

We classify real estate acquired as a result of foreclosure or by deed in lieu of foreclosure as real estate owned until such time as it is sold. We classify new and used automobile, motorcycle and all-terrain vehicles acquired as a result of foreclosure as repossessed assets until they are sold. When such property is acquired we record it at fair value less estimated selling costs.We charge any write-down of the property at the time of acquisition to the allowance for loan losses.Subsequent gains and losses are included in non-interest income and non-interest expense.

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure.Fair value is based on the appraised market value of the property based on sales of similar assets.The value may be subsequently reduced if the estimated fair value declines below the original appraised value. We monitor market information and the age of appraisals on existing real estate owned properties and obtain new appraisals as circumstances warrant.Real estate acquired through foreclosure was $8.9 million, a decrease of $13.4 million from December 31, 2012 and a decrease of $19.8 million from September 30, 2012.Real estate acquired through foreclosure at September 30, 2013 includes $3.3 million in land development properties and building lots, which are located primarily in Jefferson County compared to $9.4 million in land development and building lots at September 30, 2012.We believe that our level of real estate acquired through foreclosure has stabilized. We anticipate reductions over the next several quarters as we continue to sell OREO properties, while inflow has slowed down substantially compared to 2012 and 2011. All properties held in OREO are listed for sale with various independent real estate agents.

In the third quarter of 2012 we entered into a bulk sale contract to sell fourteen OREO properties totaling $16.5 million.We were able to close on $6.0 million and have since terminated the contract when the buyer was not able to meet all of the contractual terms and conditions of the contract. As a result of the termination on the bulk sale, we had to individually reevaluate the remaining properties.As a result, at September 30, 2013 we allocated an additional $721,000 of specific reserves to the remaining properties from the 2012 planned OREO bulk sale.

A summary of the real estate acquired through foreclosure activity is as follows:

	September 30,		December 31,
(Dollars in thousands)	2013		2012
Beginning balance, January 1,	$	22,286	$	29,083
Additions		2,262		18,100
Net proceeds from sale of properties		(13,883)		(19,250)
Writedowns		(1,585)		(5,147)
Change in valuation allowance		(221)		(500)
Ending balance	$	8,859	$	22,286

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The following table provides information with respect to non-performing assets as of the dates indicated.

	September 30,			June 30,			March 31,			December 31,			September 30,
(Dollars in thousands)	2013			2013			2013			2012			2012
Restructured on non-accrual status	$	7,927		$	8,639		$	9,099		$	9,753		$	16,151
Restructured past due 90 days still on accrual		4,837			-			-			-			-
Past due 90 days still on accrual		2,238			-			1,950			-			-
Loans on non-accrual status		6,511			9,215			9,596			11,702			15,565
Total non-performing loans		21,513			17,854			20,645			21,455			31,716
Real estate acquired through    foreclosure		8,859			14,169			19,705			22,286			28,649
Other repossessed assets		16			37			32			34			24
Total non-performing assets	$	30,388		$	32,060		$	40,382		$	43,775		$	60,389
Interest income that would have    been earned on non-performing loans	$	1,127		$	946		$	1,094		$	1,163		$	1,729
Interest income recognized    on non-performing loans		38			-			16			-			-
Ratios: Non-performing loans                 to total loans (includes loans held for                 sale in probable branch divestiture                 and probable loan sale for 2012)		4.52	%		3.64	%		4.08	%		4.09	%		5.53	%
Non-performing assets                 to total loans (includes loans held for                 sale in probable branch divestiture                 and probable loan sale for 2012)		6.38	%		6.54	%		7.98	%		8.34	%		10.53	%

Non-performing loans remained constant at September 30, 2013 compared to December 31, 2012.The change in non-accrual loans was due to a decrease in non-accrual loans following the transfer of a non-accrual relationship totaling $1.0 million to restructured status and the transfer of two non-accrual relationships totaling $1.3 million to real estate acquired through foreclosure.We also recorded $2.9 million in partial charge-offs related to loans on non-accrual.Offsetting the decrease in non-accrual loans was the addition of a commercial real estate relationship to 90 days past due and still on accrual.

Restructured loans on nonaccrual status will be placed back on accrual status if we determine that the future collection of principal and interest is reasonably assured, which requires that the borrower demonstrate a period of performance of at least six months in accordance to the restructured terms.A concentration in loans for residential subdivision development in Jefferson and Oldham counties contributed significantly to the increases in our non-performing loans and our non-performing assets during the past three years.At September 30, 2013, substantially all of our residential housing development assets in these counties have been classified as impaired and written down to what we believe to be at or near liquidation value.The remaining residential development credits are smaller and have strong guarantors.All non-performing loans are considered impaired.

The following table provides information with respect to restructured loans as of the dates indicated.

	September 30,		December 31,
(Dollar in thousands)	2013		2012
Restructured loans on non-accrual	$	7,927	$	9,753
Restructured past due 90 days still on accrual		4,837		-
Restructured loans on accrual		19,587		22,851
Total restructured loans	$	32,351	$	32,604

The decrease in restructured loans on accrual for 2013 resulted from the reclassification of a commercial real estate relationship to past due 90 days still on accrual status and due to the restructuring of three commercial real estate relationships totaling $2.4 million offset by the pay-off of a commercial real estate relationship totaling $724,000. The commercial real estate relationship that was reclassified to past due 90 days still on accrual is contractually past due but is still performing as to the payment of principal and interest.

The terms of our restructured loans have been renegotiated to reduce the rate of interest or extend the term, thus reducing the amount of cash flow required from the borrower to service the loans. We anticipate that our level of restructured loans will remain elevated as we identify borrowers in financial difficulty and work with them to modify to more affordable terms.We have worked with customers when feasible to establish “A” and “B” note structures.The “B” note is charged-off on our books but remains an outstanding balance for the customer.These typically carry a very nominal or low rate of interest.The “A” note is a note structured on a proper basis meeting internal policy standards for a performing loan.After six months of performance, the “A” note restructured loan is eligible to be placed back on an accrual basis as a performing troubled debt restructured loan.

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Investment Securities

Interest on securities provides us our largest source of interest income after interest on loans, constituting 20.5% of the total interest income for the nine months ended September 30, 2013.The securities portfolio serves as a source of liquidity and earnings, and contributes to the management of interest rate risk.We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings and loans and banks, bankers' acceptances, and federal funds.We may also invest a portion of our assets in certain commercial paper and corporate debt securities.We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The investment portfolio decreased by $63.9 million due to the sales of U.S. Treasury and agency securities, government-sponsored mortgage-backed securities,government-sponsored collateralized mortgage obligations, private asset backed and corporate bonds which sales were offset by the purchases of higher yielding investments.Recent purchases have been high cash flow instruments with short average lives in order to decrease the volatility of the investment portfolio as well as provide cash flow and limit interest rate risk.

We evaluate investment securities with significant declines in fair value on a quarterly basis to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary. We consider the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and whether management has the intent to sell the debt security or whether it is more likely than not that we will be required to sell the debt security before its anticipated recovery.In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.

The unrealized losses on our investment securities were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities.Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at September 30, 2013.See Note 3 – Securities for more information.  Management will continue to evaluate these securities for impairment quarterly.

Deposits

We rely primarily on providing excellent customer service and on our long-standing relationships with customers to attract and retain deposits. Market interest rates and rates on deposit products offered by competing financial institutions can significantly affect our ability to attract and retain deposits.We attract both short-term and long-term deposits from the general public by offering a wide range of deposit accounts and interest rates. In recent years market conditions have caused us to rely increasingly on short-term certificate accounts and other deposit alternatives that are more responsive to market interest rates.We use forecasts based on interest rate risk simulations to assist management in monitoring our use of certificates of deposit and other deposit products as funding sources and the impact of the use of those products on interest income and net interest margin in various rate environments.

Historically, we have utilized certificates of deposit placed by deposit brokers and deposits obtained through the CDARs program to support our asset growth. The CDARS system enables certificates of deposit that would exceed the current $250,000 FDIC coverage limit on deposits in a single financial institution to be redistributed to other financial institutions within the CDARS network in increments under the current coverage limit.However, due to the Bank’s designation as a “troubled institution,” we can no longer accept, renew or roll over brokered deposits (including deposits obtained through the CDARs program) without prior regulatory approval.

Total deposits decreased $175.7 million since December 31, 2012.Public funds decreased $30.3 million while retail and commercial deposits decreased $145.4 million.We have public funds deposits from school boards, water districts and municipalities within our markets.These deposits are larger than individual retail depositors.However, we do not have a deposit relationship that we believe is significant enough to cause a negative impact on our liquidity position.Brokered deposits and CDARS certificates decreased $21.3 million.Brokered deposits were $36.2 million at September 30, 2013 compared to $56.9 million at December 31, 2012.

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The following table shows the amount of our brokered deposits by time remaining until maturity.

	(Dollars in thousands)
2013	$	8,932
2014		8,579
2015		3,233
2016		1,185
2017		-
2018		4,609
2019		9,636
	$	36,174

We are currently a member of Qwickrate, which is a premier non-brokered market place that we use as an additional low cost funding source.Qwickrate deposits totaled $18.2 million at September 30, 2013 and $18.3 million at December 31, 2012.We do not anticipate a negative impact as a result of not being able to renew the $36.2 million of brokered deposits due to additional funding sources such as Qwickrate, decreased loan generation, continued loan pay downs, and our highly liquid and mostly short-term investment portfolio.

We have deployed additional resources to try to reduce our cost of funds in this low rate environment.The Consent Order resulted in the Bank being categorized as a "troubled institution" by bank regulators and as a result limits the interest rate the Bank can pay on interest bearing deposits.Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates .75% above the average rates computed by the FDIC.The Bank has elected not to pursue such a waiver and to adhere to the average rates computed by the FDIC plus the .75% rate cap.

The following table breaks down our deposits.

	September 30,		December 31,
	2013		2012
	(In Thousands)
Non-interest bearing	$	80,308	$	75,842
NOW demand		133,114		155,390
Savings		85,575		80,645
Money market		95,943		121,755
Certificates of deposit		351,938		488,988
	$	746,878	$	922,620

Advances from Federal Home Loan Bank

Deposits are the primary source of funds for our lending and investment activities and for our general business purposes.We can also use advances (borrowings) from the Federal Home Loan Bank (FHLB) to compensate for reductions in deposits or deposit inflows at less than projected levels.At September 30, 2013 outstanding FHLB advances totaled $38.4 million.At September 30, 2013, we had sufficient collateral available to borrow, approximately $5.5 million in additional advances from the FHLB. Advances from the FHLB are secured by our stock in the FHLB, certain securities and substantially all of our first mortgage loans on an individual basis.

Subordinated Debentures

Two trust subsidiaries of First Financial Service Corporation have together issued a total of $18 million trust preferred securities. The subsidiaries have loaned the sales proceeds from these issuances to us in exchange for junior subordinated deferrable interest debentures. We are not considered the primary beneficiary of these trusts, which are variable interest entities. Therefore the trusts are not consolidated in our financial statements. Rather, the subordinated debentures we have issued to them are shown as a liability.Our investment in the common stock of the trusts was $310,000.

The subordinated debentures are considered as Tier 1 capital or Tier 2 capital for the Corporation under current regulatory guidelines. Under such guidelines, capital received from the proceeds of the sale of trust preferred securities cannot constitute more than 25% of the total core capital of the Corporation.Consequently, the amount of subordinated debentures in excess of the 25% limitation constitutes Tier 2 capital for the Corporation.We have the option to defer interest payments on the subordinated debentures from time to time for a period not to exceed five consecutive years.

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In 2008, one such trust subsidiary issued $8.0 million in trust preferred securities and loaned the sales proceeds to us, which we used to finance the purchase of our Indiana banking operations. The subordinated debentures we issued to the trust mature on June 24, 2038, can be called at par in whole or in part on or after June 24, 2018, and pay a fixed rate of 8% for thirty years.

In 2007, the other trust subsidiary issued 30 year cumulative trust preferred securities totaling $10 million at a 10 year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 160 basis points.These securities mature on March 22, 2037, and can be called at par in whole or in part on or after March 15, 2017.

On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes relating to outstanding trust preferred securities.We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty.After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the subsidiary trusts will likewise suspend payment of dividends on their trust preferred securities.The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of September 30, 2013, we have deferred a total of twelve quarterly payments and these accrued but unpaid interest payments totaled $4.1 million.

LIQUIDITY

Liquidity refers to our ability to generate adequate amounts of cash to meet financial obligations to our customers and shareholders in order to fund loans, respond to deposit outflows and to cover operating expenses. Maintaining a level of liquid funds through asset/liability management seeks to ensure that these needs are met at a reasonable cost.Liquidity is essential to compensate for fluctuations in the balance sheet and provide funds for growth and normal operating expenditures.Our investment and funds management policy identifies the primary sources of liquidity, establishes procedures for monitoring and measuring liquidity, and establishes minimum liquidity requirements in compliance with regulatory guidance. The Bank management continually monitors the Bank’s liquidity position with oversight from the Asset Liability Committee.

Our banking centers provide access to retail deposit markets.If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources. In addition to maintaining a stable core deposit base, we maintain adequate liquidity primarily through the use of investment securities.Traditionally, we have also borrowed from the FHLB to supplement our funding requirements.At September 30, 2013, we had sufficient collateral available to borrow approximately $5.5 million in additional advances from the FHLB.We believe that we have adequate funding sources through unpledged investment securities, repayments of loan principal, investment securities pay downs and maturities and potential asset sales to meet our foreseeable liquidity requirements.

At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the Corporation include dividends from the Bank, borrowings and access to the capital markets.

The primary source of funding for the Corporation has been dividends and returns of investment from the Bank. Kentucky banking laws limit the amount of dividends that may be paid to the Corporation by the Bank without prior approval of the KDFI.Under these laws, the amount of dividends that may be paid in any calendar year is limited to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods.Our Consent Order requires us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends to the Corporation.

The Corporation has also entered into a formal agreement with the Federal Reserve to obtain regulatory approval before declaring any dividends on our common or preferred stock.We will not be able to pay cash dividends on our common stock in the future until we first pay all unpaid dividends on the Senior Preferred Shares and all deferred distributions on our trust preferred securities.We may not redeem shares or obtain additional borrowings without prior approval.Because of these limitations, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available to the Corporation.During the first nine months of 2013, the Bank did not declare or pay any dividends to the Corporation.Cash held by the Corporation at September 30, 2013 was $200,000 compared to cash of $333,000 at December 31, 2012.

CAPITAL

Stockholders’ equity decreased $9.8 million for the period ended September 30, 2013, primarily due to an increase in unrealized losses on securities available-for-sale during the period.Our average stockholders’ equity to average assets ratio decreased to 4.19% for the nine months ended September 30, 2013 compared to 4.40% for the 2012 period.

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On January 9, 2009, we sold $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the U.S. Treasury (“Treasury”) under the terms of its Capital Purchase Program.The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares.The Senior Preferred Shares pay cumulative dividends at a rate of 5% per year for the first five years and will reset to a rate of 9% per year on January 9, 2014.

Under the terms of our CPP stock purchase agreement, we also issued Treasury a warrant to purchase an amount of our common stock equal to 15% of the aggregate amount of the Senior Preferred Shares, or $3 million.The warrant entitles Treasury to purchase 215,983 common shares at a purchase price of $13.89 per share.The initial exercise price for the warrant and the number of shares subject to the warrant were determined by reference to the market price of our common stock calculated on a 20-day trailing average as of December 8, 2008, the date Treasury approved our application.The warrant has a term of 10 years and is potentially dilutive to earnings per share.

Effective with the fourth quarter of 2010, we suspended payment of regular quarterly cash dividends on our Senior Preferred Shares.The dividends are cumulative and will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes.

On April 29, 2013, Treasury sold our Senior Preferred Shares to six in an auction. Following the sale, the full $20 million stated value of our Senior Preferred Shares remains outstanding and our obligation to pay deferred and future dividends continues until our Senior Preferred Shares are fully retired.

During the first nine months of 2013, we did not purchase any shares of our common stock.Like our agreement with the Federal Reserve, the terms of our Senior Preferred Shares do not allow us to repurchase shares of our common stock without prior written consent until the Senior Preferred Shares are fully retired.

Each of the federal bank regulatory agencies has established minimum leverage capital requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.

The following table shows the ratios of Tier 1 capital, total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of September 30, 2013.

	Capital Adequacy Ratios as of
	September 30, 2013
	Regulatory		Ratio Required
Risk-Based Capital Ratios	Minimums		by Consent Order		The Bank		The Corporation
Tier 1 capital	4.00	%	N/A		11.83	%	10.00	%
Total risk-based capital	8.00	%	12.00	%	13.09	%	11.88	%
Tier 1 leverage ratio	4.00	%	9.00	%	7.80	%	6.60	%

In its 2012 Consent Order, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012.At September 30, 2013, the Bank’s Tier 1 capital ratio was 7.80% and the total risk-based capital ratio was 13.09%.We notified the bank regulatory agencies that one of the two capital ratios would not be achieved and are continuing our efforts to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank.

The terms of the 2012 Consent Order and the actions we have taken to attain the capital ratios and meet the other requirements of the Order are described in greater detail in the Regulatory Matters to this section.

Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset/Liability Management and Market Risk

To minimize the volatility of net interest income and exposure to economic loss that may result from fluctuating interest rates, we manage our exposure to adverse changes in interest rates through asset and liability management activities within guidelines established by our Asset Liability Committee (“ALCO”).Comprised of senior management representatives, the ALCO has the responsibility for approving and ensuring compliance with asset/liability management policies.Interest rate risk is the exposure to adverse changes in the net interest income as a result of market fluctuations in interest rates.The ALCO, on an ongoing basis, monitors interest rate and liquidity risk in order to implement appropriate funding and balance sheet strategies.Management considers interest rate risk to be our most significant market risk.

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We utilize an earnings simulation model to analyze net interest income sensitivity.We then evaluate potential changes in market interest rates and their subsequent effects on net interest income.The model projects the effect of instantaneous movements in interest rates of both 100 and 200 basis points.We also incorporate assumptions based on the historical behavior of our deposit rates and balances in relation to changes in interest rates into the model.These assumptions are inherently uncertain and, as a result, the model cannot precisely measure future net interest income or precisely predict the impact of fluctuations in market interest rates on net interest income.Actual results will differ from the model’s simulated results due to timing, magnitude and frequency of interest rate changes as well as changes in market conditions and the application and timing of various management strategies.

Our interest sensitivity profile was asset sensitive at September 30, 2013 and December 31, 2012.Given a sustained 100 basis point increase in interest rates, our base net interest income would increase by an estimated 3.15 % at September 30, 2013 compared to an increase of 9.21% at December 31, 2012.

We did not run a model simulation for declining interest rates as of September 30, 2013 and December 31, 2012, because the Federal Open Market Committee effectively lowered the Fed Funds Target Rate between 0.00% to 0.25% in December 2008 and therefore, no further short-term rate reductions can occur.

Our interest sensitivity at any point in time will be affected by a number of factors.These factors include the mix of interest sensitive assets and liabilities, their relative pricing schedules, market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.

We use various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking.As demonstrated by the September 30, 2013 and December 31, 2012 sensitivity tables, our balance sheet has an asset sensitive position. This means that our earning assets, which consist of loans and investment securities, will change in price at a faster rate than our deposits and borrowings.Therefore, if short term interest rates increase, our net interest income will increase.Likewise, if short term interest rates decrease, our net interest income will decrease.

Our sensitivity to interest rate changes is presented based on data as of September 30, 2013 and December 31, 2012 annualized to a one year period.

			September 30, 2013
			Increase in Rates
				100		200
(Dollars in thousands)	Base		Basis Points			Basis Points
Projected interest income	$	28,703	$	32,553		$	36,580
Projected interest expense		6,121		9,260			12,399
Net interest income	$	22,582	$	23,293		$	24,181
Change from base			$	711		$	1,599
% Change from base				3.15	%		7.08	%

			December 31, 2012
			Increase in Rates
				100		200
(Dollars in thousands)	Base		Basis Points			Basis Points
Projected interest income	$	34,262	$	38,129		$	41,653
Projected interest expense		9,458		11,044			12,631
Net interest income	$	24,804	$	27,085		$	29,022
Change from base			$	2,281		$	4,218
% Change from base				9.21	%		17.01	%

The increase in projected interest expense from base at September 30, 2013 is related to our $20 million stated value of Senior Preferred Shares. Our obligation to pay deferred and future dividends on our Senior Preferred Shares, currently at an annual rate of 5% and increasing to 9% in January 2014, continues until they are retired.

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Item 4.  CONTROLS AND PROCEDURES

Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of September 30, 2013, an evaluation was performed under the supervision and with the participation of management, including the Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures.Based on that evaluation, management and the Risk Management Committee of our Board of Directors concluded that disclosure controls and procedures were effective as of the end of the period covered by this report.

Management is responsible for establishing and maintaining adequate internal controls over financial reporting that are designed to produce reliable financial statements in accordance with U.S. generally accepted accounting principles.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.

There were no other changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2013 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II - OTHER INFORMATION

Item 1. Legal Proceedings

On June 21, 2012, a lawsuit was filed against the Bank in Jefferson County, Kentucky circuit court. River Glen KHLB, LLC and Keith T. Eberenz vs. First Federal Savings Bank of Elizabethtown, Civil Action No. 12CI03473. The plaintiffs allege fraud, negligent misrepresentation, failure to fund various loans, breach of fiduciary duty and breach of the duty of good faith and fair dealing.Plaintiffs seek compensatory and punitive damages, pre-judgment interest, costs including reasonable attorneys’ fees, and equitable relief. The Bank filed its answer on June 29, 2012 denying the allegations and a counterclaim seeking judgment for the balances due on promissory notes, enforcement of a guaranty contract and an assignment of rents, foreclosure, and the appointment of a receiver.On July 16, 2012, the court appointed an independent manager to preserve and manage the property, collect rents, pay operating expenses, property taxes, insurance premiums and utilities, and pay the monthly loan payment into an escrow fund.On September 13, 2013, the court granted a partial summary judgment in favor of the Bank on its counterclaims.Plaintiffs have asked the court to reconsider its order.This matter is pending.Discovery in this matter is ongoing.We intend to vigorously defend the allegations against the Bank and pursue its claims. Management continues to closely monitor this case, but is unable to estimate, at this time, the possible loss or range of possible loss, if any, that may result from this lawsuit.

On February 11, 2013, seven plaintiffs filed a lawsuit in federal district court in Louisville, Kentucky against the Bank and two co-defendants. William P. Miller, et al. v. First Federal Savings Bank of Elizabethtown, Inc., et. al., No. 3:13-cv-206 M (W.D. Ky.). Plaintiffs allege they invested in two companies organized by one of the co-defendants, which companies purchased commercial property in Addison, Illinois. Plaintiffs also guaranteed loans made by the Bank to the two companies in the principal amount of $3,125,622.74.Plaintiffs allege that the Bank and the co-defendants engaged in a pattern of fraudulent acts, including violations of federal mail fraud, wire fraud, financial institution fraud and conspiracy statutes, which induced plaintiffs to enter into the guaranty agreement with the Bank.Plaintiffs also allege intentional misrepresentation, negligence, and civil conspiracy against all of the co-defendants.Plaintiffs seek compensatory and punitive damages, as well as treble damages under federal racketeering statutes and court costs and legal fees. The Bank has filed its answer in this matter.The Bank subsequently filed a motion for judgment on the pleadings requesting that the federal law claims be dismissed from the case.That motion is now fully briefed and waiting the court’s ruling.In addition, two days after plaintiffs filed their complaint, the Bank filed a foreclosure action in Illinois state court related to the commercial property underlying the Kentucky proceedings. First Federal Savings Bank v. Addent, LLC, et. al., No. 2013-CH-000570 (Illinois Circuit Court, DuPage County).We intend to vigorously defend the allegations against the Bank and pursue the foreclosure action on the underlying property.

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Item 1A.       Risk Factors

Investing in First Financial Service Corporation’s stock involves various risks which are particular to our company, our industry and our market area. We believe all significant risks to investors in First Financial Service Corporation have been outlined in Part I, Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2012. However, other risks may prove to be important in the future, and new risks may emerge at any time. We cannot predict with certainty all potential developments which could materially affect our financial performance or condition.There has been no material change to our risk factors as previously disclosed in the above described Annual Report on Form 10-K.

Item 2. Unregistered Sales of Securities and Use of Proceeds

We did not repurchase any shares of our common stock during the quarter ended September 30, 2013.

Item 3.          Defaults Upon Senior Securities

Not Applicable

Item 4.          Mine Safety Disclosures

Not Applicable

Item 5. Other Information

On October 30, 2013, the Corporation and B. Keith Johnson, a director and former chief executive officer of the Corporation and First Federal Savings Bank, mutually agreed to terminate 27,641 shares of long-term restricted stock awarded to Johnson on December 31, 2010 that remained subject to permanent transfer restrictions following the sale of the Corporation’s preferred stock by the United States Treasury at a discount to the issuance price.In consideration, the Corporation issued 27,641 shares of common stock to Mr. Johnson, of which 22,112 shares are subject to forfeiture until Mr. Johnson meets service-based vesting conditions between January 1, 2014 and May 2015.In addition, as a further condition to the vesting of 16,585 of the restricted shares in May 2014 and thereafter, Mr. Johnson agreed to execute and deliver a release to the Corporation upon the completion of his duties under the Corporation’s management succession plan adopted in February 2012.

Item 6. Exhibits:

10.1	Restricted Stock Award Agreement dated October 30, 2013 with B. Keith Johnson
10.2	Restricted Stock Termination Agreement and Release dated October 30, 2013 with B. Keith Johnson
31.1	Certification of Principal Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
32	Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
101	The following financial information from the Quarterly Report of First Financial Service Corporation on Form 10-Q for the quarter ended September 30, 2013, formatted in XBRL: (i) Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012, (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2013 and 2012, (iii) Consolidated Statements of Comprehensive Income/(Loss) for the three and nine months ended September 30, 2013 and 2012, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2013, (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012, and (vi) Notes to the Unaudited Consolidated Financial Statements.

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FIRST FINANCIAL SERVICE CORPORATION

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

Date:November 14, 2013	By:	/s/ Gregory S. Schreacke
		Gregory S. Schreacke
		President
		Principal Executive Officer
		Duly Authorized Representative
Date:November 14, 2013	By:	/s/ Frank Perez
		Frank Perez
		Chief Financial Officer
		Principal Financial Officer

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INDEX TO EXHIBITS

Exhibit No.	Description
10.1	Restricted Stock Award Agreement dated October 30, 2013 with B. Keith Johnson
10.2	Restricted Stock Termination Agreement and Release dated October 30, 2013 with B. Keith Johnson
31.1	Certification of Principal Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
32	Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
101	The following financial information from the Quarterly Report of First Financial Service Corporation on Form 10-Q for the quarter ended September 30, 2013, formatted in XBRL: (i) Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012, (ii) Consolidated Statements of Operations for the three and nine months ended September 30, 2013 and 2012, (iii) Consolidated Statements of Comprehensive Income/(Loss) for the three and nine months ended September 30, 2013 and 2012, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2013, (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012, and (vi) Notes to the Unaudited Consolidated Financial Statements.

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