- Quarterly Report (10-Q)

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, 2011

¨	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
Elizabethown, Kentucky 42701		(Registrant's telephone number,
(Address of principal executive offices)		including area code)
(Zip Code)

(270) 765-2131

(Registrant's telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate 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 x Smaller Reporting Company ¨

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, 2011

Common Stock		4,749,072 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	5

Item 2.	Management's Discussion and Analysis of Financial
	Condition and Results of Operations	34

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	52

Item 4.	Controls and Procedures	54

PART II – OTHER INFORMATION

Item 1.	Legal Proceedings	54

Item 1A.	Risk Factors	54

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	56

Item 3.	Defaults upon Senior Securities	56

Item 4.	[Removed and Reserved]	56

Item 5.	Other Information	56

Item 6.	Exhibits	56

SIGNATURES		57

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 this report and our Annual Report on Form 10-K, the following factors could cause such differences: 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 determined by the Federal Reserve Board, the Federal Deposit Insurance Corporation (“FDIC”) and 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 after the date of the statement to reflect the occurrence of unanticipated events.

Item 1.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Balance Sheets

(Unaudited)

	September 30,			December 31,
(Dollars in thousands, except share and per share data)	2011			2010

ASSETS:
Cash and due from banks	$	13,581		$	14,840
Interest bearing deposits		20,367			151,336
Total cash and cash equivalents		33,948			166,176

Securities available-for-sale		332,357			196,029
Securities held-to-maturity, fair value of $23 Sept (2011) and $126 Dec (2010)		23			124
Total securities		332,380			196,153

Loans held for sale		7,367			6,388
Loans, net of unearned fees		765,712			884,531
Allowance for loan losses		(16,018	)		(22,665	)
Net loans		757,061			868,254

Federal Home Loan Bank stock		4,805			4,909
Cash surrender value of life insurance		9,613			9,354
Premises and equipment, net		31,022			31,988
Real estate owned:
Acquired through foreclosure		29,180			25,807
Held for development		45			45
Other repossessed assets		36			40
Core deposit intangible		777			994
Accrued interest receivable		3,268			3,807
Accrued income taxes		10,073			2,161
Deferred income taxes		-			2,982
Prepaid FDIC Insurance		1,965			4,449
Other assets		9,636			2,388

TOTAL ASSETS	$	1,223,809		$	1,319,507

LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Deposits:
Non-interest bearing	$	77,892		$	73,566
Interest bearing		1,030,508			1,100,342
Total deposits		1,108,400			1,173,908

Advances from Federal Home Loan Bank		27,770			52,532
Subordinated debentures		18,000			18,000
Accrued interest payable		1,476			594
Accounts payable and other liabilities		5,022			3,162
Deferred income taxes		6,734			-

TOTAL LIABILITIES		1,167,402			1,248,196
Commitments and contingent liabilities		-			-

STOCKHOLDERS' EQUITY:
Serial preferred stock, $1 par value per share; authorized 5,000,000 shares; issued and outstanding, 20,000 shares with a liquidation preference of $20,000		19,876			19,835
Common stock, $1 par value per share; authorized 35,000,000 shares; issued and outstanding, 4,749,072 shares Sept (2011), and 4,726,329 shares Dec (2010)		4,749			4,726
Additional paid-in capital		35,407			35,201
Retained earnings/(accumulated deficit)		(5,937	)		16,264
Accumulated other comprehensive income/(loss)		2,312			(4,715	)

TOTAL STOCKHOLDERS' EQUITY		56,407			71,311
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY	$	1,223,809		$	1,319,507

See notes to the unaudited consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Income

(Unaudited)

	Three Months Ended						Nine Months Ended
(Dollars in thousands, except share and per share data)	September 30,						September 30,
	2011			2010			2011			2010
Interest and Dividend Income:
Loans, including fees	$	10,844		$	13,543		$	34,879		$	41,857
Taxable securities		1,816			1,117			5,085			2,488
Tax exempt securities		265			255			787			628
Total interest income		12,925			14,915			40,751			44,973

Interest Expense:
Deposits		4,430			4,883			14,018			14,642
Short-term borrowings		-			6			-			38
Federal Home Loan Bank advances		282			599			857			1,788
Subordinated debentures		341			331			1,032			989
Total interest expense		5,053			5,819			15,907			17,457

Net interest income		7,872			9,096			24,844			27,516
Provision for loan losses		6,124			6,327			19,106			11,353
Net interest income after provision for loan losses		1,748			2,769			5,738			16,163

Non-interest Income:
Customer service fees on deposit accounts		1,620			1,671			4,619			4,935
Gain on sale of mortgage loans		268			513			824			1,227
Gain on sale of investments		92			7			323			7
Loss on sale of investments		-			-			(38	)		(23	)
Other than temporary impairment loss:
Total other-than-temporary impairment losses		(64	)		(649	)		(168	)		(832	)
Portion of loss recognized in other comprehensive income/(loss) (before taxes)		-			-			-			-
Net impairment losses recognized in earnings		(64	)		(649	)		(168	)		(832	)
Loss on sale and write downs on real estate acquired through foreclosure		(3,315	)		(374	)		(8,201	)		(838	)
Brokerage commissions		124			109			339			309
Other income		348			703			1,203			1,514
Total non-interest income		(927	)		1,980			(1,099	)		6,299

Non-interest Expense:
Employee compensation and benefits		4,060			4,176			12,347			12,171
Office occupancy expense and equipment		804			779			2,447			2,351
Marketing and advertising		101			225			490			675
Outside services and data processing		874			622			2,727			2,020
Bank franchise tax		342			566			998			1,482
FDIC insurance premiums		679			615			2,555			1,969
Amortization of core deposit intangible		64			77			217			229
Real estate acquired through foreclosure expense		476			302			1,504			916
Loan expense		1,358			129			2,169			328
Other expense		1,282			1,223			3,908			3,481
Total non-interest expense		10,040			8,714			29,362			25,622

Income/(loss) before income taxes		(9,219	)		(3,965	)		(24,723	)		(3,160	)
Income taxes/(benefits)		(1,783	)		(1,472	)		(3,313	)		(1,359	)
Net Income/(Loss)		(7,436	)		(2,493	)		(21,410	)		(1,801	)
Less:
Dividends on preferred stock		(250	)		(250	)		(750	)		(750	)
Accretion on preferred stock		(14	)		(14	)		(41	)		(41	)
Net income (loss) attributable to common shareholders	$	(7,700	)	$	(2,757	)	$	(22,201	)	$	(2,592	)

Shares applicable to basic income per common share		4,746,780			4,724,043			4,741,152			4,719,513
Basic income (loss) per common share	$	(1.62	)	$	(0.58	)	$	(4.68	)	$	(0.55	)

Shares applicable to diluted income per common share		4,746,780			4,724,043			4,741,152			4,719,513
Diluted income (loss) per common share	$	(1.62	)	$	(0.58	)	$	(4.68	)	$	(0.55	)

Cash dividends declared per common share	$	-		$	-		$	-		$	-

See notes to the unaudited consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Comprehensive Income

(Unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(Dollars in thousands)		2011			2010			2011			2010

Net Income/(Loss)	$	(7,436	)	$	(2,493	)	$	(21,410	)	$	(1,801	)
Other comprehensive income (loss):
Change in unrealized gain (loss) on securities available-for-sale		4,575			1,103			10,498			2,551
Change in unrealized gain (loss) on securities available-for-sale for which a portion of other-than-temporary impairment has been recognized into earnings		(26	)		(6	)		267			(53	)
Reclassification of realized amount on securities available-for-sale losses (gains)		(34	)		641			(202	)		798
Reclassification of unrealized loss on held-to-maturity security recognized in income		6			1			85			50
Accretion (amortization) of non-credit component of other-than-temporary impairment on held-to-maturity securities		-			-			(1	)		(1	)
Net unrealized gain (loss) recognized in comprehensive income		4,521			1,739			10,647			3,345
Tax effect		(1,537	)		(591	)		(3,620	)		(1,137	)
Total other comphrehensive income		2,984			1,148			7,027			2,208

Comprehensive Income/(Loss)	$	(4,452	)	$	(1,345	)	$	(14,383	)	$	407

The following is a summary of the accumulated other comprehensive income balances, net of tax:

	Balance			Current		Balance
	at			Period		at
	12/31/2010			Change		9/30/2011
Unrealized gains (losses) on securities available-for-sale	$	(5,691	)	$	6,740	$	1,049
Unrealized gains (losses) on available-for-sale securities for which OTTI has been recorded,		1,082			231		1,313
Unrealized gains (losses) on held-to-maturity securities for which OTTI has been recorded, net of accretion		(106	)		56		(50	)

Total	$	(4,715	)	$	7,027	$	2,312

See notes to the unaudited consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Changes in Stockholders' Equity

Nine Months Ended September 30, 2011

(Dollars In Thousands, Except Per Share Amounts)

(Unaudited)

														Accumulated
														Other
									Additional					Comprehensive
	Shares				Amount				Paid-in		Retained			(Loss), Net of
	Preferred		Common		Preferred		Common		Capital		Earnings			Tax			Total

Balance, January 1, 2011		20,000		4,726	$	19,835	$	4,726	$	35,201	$	16,264		$	(4,715	)	$	71,311
Net loss												(21,410	)					(21,410	)
Shares issued under dividend reinvestment program				1				1		1								2
Stock issued for employee benefit plans				22				22		62								84
Stock-based compensation expense										143								143
Net change in unrealized gains (losses) on securities available-for-sale,															6,740			6,740
Change in unrealized gains (losses) on held-to-maturity securities for which an other-than-temporary impairment charge has been recorded,															56			56
Change in unrealized gains (losses) on securities available-for-sale for which a portion of an other-than-temporary impairment charge has been recognized into earnings, net of reclassification															231			231
Dividends on preferred stock												(750	)					(750	)
Accretion of preferred stock discount		-		-		41		-		-		(41	)		-			-
Balance, September 30, 2011		20,000		4,749	$	19,876	$	4,749	$	35,407	$	(5,937	)	$	2,312		$	56,407

See notes to the unaudited consolidated financial statements.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Cash Flows

(Dollars In Thousands)

(Unaudited)

	Nine Months Ended
	September 30,
	2011			2010
Operating Activities:
Net income/(loss)	$	(21,410	)	$	(1,801	)
Adjustments to reconcile net income to net cash provided by operating activities:
Provision for loan losses		19,106			11,353
Depreciation on premises and equipment		1,258			1,320
Core deposit intangible amortization		217			229
Net amortization (accretion) available-for-sale		(5,466	)		(1,554	)
Impairment loss on securities available-for-sale		83			782
Impairment loss on securities held-to-maturity		85			50
Loss on sale of investments held-to-maturity		3			-
Loss on sale of investments available-for-sale		35			23
Gain on sale of investments available-for-sale		(323	)		(7	)
Gain on sale of mortgage loans		(824	)		(1,227	)
Origination of loans held for sale		(62,168	)		(96,445	)
Proceeds on sale of loans held for sale		62,013			92,642
Stock-based compensation expense		143			71
Prepaid FDIC premium		2,484			1,859
Changes in:
Cash surrender value of life insurance		(259	)		(258	)
Interest receivable		539			173
Other assets		1,481			(560	)
Interest payable		882			(114	)
Accounts payable and other liabilities		1,110			(1,750	)
Net cash from operating activities		(1,011	)		4,786

Investing Activities:
Sales of securities available-for-sale		128,289			665
Sales of securities held-to-maturity		92			-
Purchases of securities available-for-sale		(286,744	)		(179,022	)
Maturities of securities available-for-sale		38,360			63,424
Maturities of securities held-to-maturity		6			1,038
Net change in loans		79,152			60,789
Redemption of Federal Home Loan Bank stock		104			3,500
Net purchases of premises and equipment		(292	)		(1,672	)
Net cash from investing activities		(41,033	)		(51,278	)

Financing Activities
Net change in deposits		(65,508	)		38,911
Change in short-term borrowings		-			(1,155	)
Advance from Federal Home Loan Bank		337			-
Maturity of Federal Home Loan Bank advance		(25,000	)		-
Repayments to Federal Home Loan Bank		(99	)		(181	)
Issuance of common stock under dividend reinvestment program		2			16
Issuance of common stock for employee benefit plans		84			116
Dividends paid on preferred stock		-			(750	)
Net cash from financing activities		(90,184	)		36,957

(Decrease) Increase in cash and cash equivalents		(132,228	)		(9,535	)
Cash and cash equivalents, beginning of period		166,176			98,533
Cash and cash equivalents, end of period	$	33,948		$	88,998

Supplemental noncash disclosures:
Transfers from loans to real estate owned	$	16,140		$	10,434

See notes to the unaudited consolidated financial statements.

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 and its wholly owned subsidiary, First Federal Savings 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 direct and indirect wholly owned subsidiaries. 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, 2011 are not necessarily indicative of the results that may occur for the year ending December 31, 2011. 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, 2010, as amended by Form 10-K/A filed May 13, 2011.

Adoption of New Accounting Standards – In April 2011, the FASB issued ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring , which clarifies when creditors should classify loan modifications as troubled debt restructurings. The guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the year. The guidance on measuring the impairment of a receivable restructured in a troubled debt restructuring, as clarified, is effective on a prospective basis. The new standard did not have a material impact on our consolidated financial position or results of operations.

In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. The amendments in this ASU generally represent clarifications of Topic 820, but also include some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. This ASU results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRSs. The amendments in this ASU are to be applied prospectively and are effective for interim and annual periods beginning after December 31, 2011. The new standard is not expected to have a material impact on our consolidated financial position or results of operations.

In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income , which amends existing guidance by allowing only two options for presenting the components of net income and other comprehensive income: (1) in a single continuous financial statement, statement of comprehensive income or (2) in two separate but consecutive financial statements, consisting of an income statement followed by a separate statement of other comprehensive income. There is currently a proposal to defer the requirement to disclose items that are reclassified from other comprehensive income to net income on the face of the financial statements. ASU No. 2011-05 requires retrospective application, and it is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 (for us this will be our 2012 first quarter), with early adoption permitted. The new standard is not expected to have a material impact on our consolidated financial position or results of operations.

Reclassifications – Some items in the prior year financial statements were classified to conform to the current presentation.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

2.	REGULATORY MATTERS

On January 27, 2011, the Bank entered into a Consent Order, a formal agreement with the FDIC and KDFI, under which, among other things, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of 8.5% and a total risk-based capital ratio of 11.5% by March 31, 2011 and achieve and maintain a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2011. At March 31, June 30, and September 30, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements. We notified the bank regulatory agencies that the increased capital levels would not be achieved. We remain in regular contact with the FDIC and KDFI, and expect the agencies will reevaluate our progress toward the higher capital ratios at March 31, 2012.

The Bank’s Consent Order with the FDIC and KDFI 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. We are also no longer allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval. Brokered deposits were $90.3 million at September 30, 2011.

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

In order to meet these capital requirements, we have engaged an investment banking firm with expertise in the financial services sector to assist with a review of strategic opportunities available to us. We continue reducing our costs where possible while taking into consideration the resources necessary to execute our strategies. We have suspended the annual employee stock ownership contribution, frozen executive management compensation the past three years and into 2012, frozen officer compensation for the past year and into 2012, eliminated board of director fees, reduced marketing expenses, reduced community donation expense, reduced compensation expense by $500,000 through reductions in associates, and implemented various other cost savings initiatives. Expense reductions for 2011 are estimated to be $1.2 million. Additional cost reductions for 2012 are projected to be in excess of $1.0 million. We are also evaluating remaining terms on existing contracts and identifying expenses we cannot reduce currently, but expect to be able to in 2012 and 2013, such as FDIC insurance, examination fees and loan workout and other real estate owned expenses. These efforts will remain ongoing.

Our plans for the fourth quarter of 2011 include the following:

Pursue all available strategies to recapitalize the Bank. We have an ongoing process to evaluate such strategies as raising capital by selling capital stock, the sale of branch assets, or the sale of the Bank or the Company as a whole.

Continue 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. The strength of this franchise contributes to earnings to help withstand our credit quality issues. In addition, the inherent value of the retail franchise will provide value to the Bank to accomplish the various capital initiatives.

Continue to reduce our lending concentration in commercial real estate by obtaining pay downs and payoffs. In addition to allowing loans in these concentrations to roll off, we have started initiatives to diversify the Bank’s lending portfolio and change our lending culture. The mortgage and consumer lending operations have maintained strong credit quality metrics through this recession. These areas are being restructured to allow for additional emphasis on retail lending going forward. We will also emphasize small business lending and will seek resources to add expertise in this area. Our efforts will focus on back to basic community banking and servicing the entire relationship of the customer. These loans will be used to diversify the loan portfolio of the Bank as well as provide for profitability as the Bank works through our credit quality issues.

Bank regulatory agencies can exercise 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.

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, 2011:
U.S. Treasury and agencies	$	51,988	$	96	$	(8	)	$	52,076
Government-sponsored mortgage-backed residential		251,259		4,625		(120	)		255,764
Equity		299		-		(6	)		293
State and municipal		22,321		1,530		-			23,851
Trust preferred securities		1,042		-		(669	)		373

Total	$	326,909	$	6,251	$	(803	)	$	332,357

December 31, 2010:
U.S. Treasury and agencies	$	117,886	$	97	$	(4,090	)	$	113,893
Government-sponsored mortgage-backed residential		59,320		448		(598	)		59,170
Equity		299		-		(6	)		293
State and municipal		22,564		264		(210	)		22,618
Trust preferred securities		1,074		-		(1,019	)		55

Total	$	201,143	$	809	$	(5,923	)	$	196,029

			Gross		Gross
	Amortized		Unrecognized		Unrecognized
	Cost		Gains		Losses		Fair Value
Securities held-to-maturity:
September 30, 2011:
Trust preferred securities	$	23	$	-	$	-	$	23

Total	$	23	$	-		-	$	23


December 31, 2010:
Government-sponsored mortgage-backed residential	$	102	$	2	$	-	$	104
Trust preferred securities		22		-		-		22

Total	$	124	$	2	$	-	$	126

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3.	SECURITIES – (Continued)

The amortized cost and fair value of securities at September 30, 2011, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed and equity securities, are shown separately.

	Available for Sale				Held-to-Maturity
	Amortized		Fair		Amortized		Fair
(Dollars in thousands)	Cost		Value		Cost		Value

Due in one year or less	$	115	$	115	$	-	$	-
Due after one year through five years		2,000		2,004		-		-
Due after five years through ten years		313		335		-		-
Due after ten years		72,923		73,846		23		23
Government-sponsored mortgage-backed residential		251,259		255,764		-		-
Equity		299		293		-		-
	$	326,909	$	332,357	$	23	$	23

For the September 30, 2011 nine month period, proceeds from sales of available-for-sale and held-to-maturity debt securities were $128.4 million and for the 2010 period, proceeds from sales of available-for-sale equity securities were $665,000. Gross realized gains recognized in income in 2011 were $323,000 and gross realized losses recognized were $38,000. Gross realized gains recognized in income in 2010 were $7,000 and gross realized losses recognized were $23,000.

Investment securities pledged to secure public deposits and FHLB advances had an amortized cost of $71.1 million and fair value of $72.3 million at September 30, 2011 and a $66.8 million amortized cost and fair value of $65.1 million at December 31, 2010.

Securities with unrealized losses at September 30, 2011 and December 31, 2010 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:

September 30, 2011	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	$	4,992	$	(8	)	$	-	$	-		$	4,992	$	(8	)
Government-sponsored mortgage-backed residential		30,170		(120	)		-		-			30,170		(120	)
Equity	$	-	$	-			3		(6	)		3		(6	)
Trust preferred securities		-		-			373		(669	)		373		(669	)

Total temporarily impaired	$	35,162	$	(128	)	$	376	$	(675	)	$	35,538	$	(803	)

December 31, 2010	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	$	70,896	$	(4,090	)	$	-	$	-		$	70,896	$	(4,090	)
Government-sponsored mortgage-backed residential		22,084		(598	)		-		-			22,084		(598	)
Equity		3		(6	)		-		-			3		(6	)
State and municipal		11,095		(157	)		527		(53	)		11,622		(210	)
Trust preferred securities		-		-			55		(1,019	)		55		(1,019	)

Total temporarily impaired	$	104,078	$	(4,851	)	$	582	$	(1,072	)	$	104,660	$	(5,923	)

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3.	SECURITIES – (Continued)

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 securities held to maturity and securities available for sale.

The unrealized losses on our U. S. Treasury and agency securities and our government sponsored mortgage-backed residential 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, 2011.

As discussed in Note 9 - Fair Value, the fair value of our portfolio of trust preferred securities, has decreased significantly. There is limited trading in trust preferred securities and the majority of holders of such instruments have elected not to participate in the market unless they are required to sell as a result of liquidation, bankruptcy, or other forced or distressed conditions.

To determine if the five trust preferred securities were other than temporarily impaired as of September 30, 2011, we used a discounted cash flow analysis. The cash flow models were used to determine if the current present value of the cash flows expected on each security were still equivalent to the original cash flows projected on the security when purchased. The cash flow analysis takes into consideration assumptions for prepayments, defaults and deferrals for the underlying pool of banks, insurance companies and REITs.

Management works with independent third parties to identify its best estimate of the cash flow expected to be collected. If this estimate results in a present value of expected cash flows that is less than the amortized cost basis of a security (that is, credit loss exists), an other than temporary impairment is considered to have occurred. If there is no credit loss, any impairment is considered temporary. The cash flow analysis we performed included the following general assumptions:

We assume default rates on individual entities behind the pools based on Fitch ratings for financial institutions and A.M. Best ratings for insurance companies. These ratings are used to predict the default rates for the next several quarters. Two of the trust preferred securities hold a limited number of real estate investment trusts (REITs) in their pools. REITs are evaluated on an individual basis to predict future default rates.

We assume that annual defaults for the remaining life of each security will be between 37.5 and 100 basis points.

We assume a recovery rate of 40% on PreTSL IV and 15% on the remaining trust preferred securities on deferrals after two years.

We assume 1% prepayments through the five year par call and then 1% per annum for the remaining life of PreTSL IV to account for the potential prepayments of large banks under the new Dodd Frank legislation.

Our securities have been modeled using the above assumptions by FTN Financial using the forward LIBOR curve plus original spread to discount projected cash flows to present values.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3.	SECURITIES – (Continued)

Additionally, in making our determination, we considered all available market information that could be obtained without undue cost and effort, and considered the unique characteristics of each trust preferred security individually by assessing the available market information and the various risks associated with that security including:

Valuation estimates provided by our investment broker;

The amount of fair value decline;

How long the decline in fair value has existed;

Significant rating agency changes on the issuer;

Level of interest rates and any movement in pricing for credit and other risks;

Information about the performance of the underlying institutions that issued the debt instruments, such as net income, return on equity, capital adequacy, non-performing assets, Texas ratios, etc;

Our intent to sell the security or whether it is more likely than not that we will be required to sell the security before its anticipated recovery; and

Other relevant observable inputs.

The following table details the five debt securities with other-than-temporary impairment at September 30, 2011 and the related credit losses recognized in earnings during the nine months ended September 30, 2011:

		Moody's											% of Current
		Credit		Current							Current		Deferrals and
(Dollars in thousands)		Ratings		Moody's					Estimated		Deferrals		Defaults			Year to Date
		When		Credit	Par		Amortized		Fair		and		to Current			OTTI
Security	Tranche	Purchased		Ratings	Value		Cost		Value		Defaults		Collateral			Recognized

Preferred Term Securities IV	Mezzanine		A3	Ca	$	244	$	180	$	118	$	18,000		27	%	$	59
Preferred Term Securities VI	Mezzanine		A1	Caa1		266		23		23		30,000		74	%		85
Preferred Term Securities XV B1	Mezzanine		A2	Ca		1,048		434		182		217,700		36	%		-
Preferred Term Securities XXI C2	Mezzanine		A3	Ca		1,142		401		72		209,890		29	%		24
Preferred Term Securities XXII C1	Mezzanine		A3	Ca		520		84		1		414,500		32	%		-

Total					$	3,220	$	1,122	$	396						$	168

The table below presents a roll-forward of the credit losses recognized in earnings for the periods ended September 30, 2011 and 2010:

(Dollars in thousands)	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2011		2010		2011		2010

Beginning balance	$	2,014	$	1,045	$	1,910	$	862
Increases to the amount related to the credit loss for which other-than-temporary impairment was previously recognized		64		649		168		832
Ending balance	$	2,078	$	1,694	$	2,078	$	1,694

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

LOANS

Loans are summarized as follows:

	September 30,			December 31,
(Dollars in thousands)	2011			2010

Commercial	$	31,910		$	44,747
Commercial Real Estate:
Land Development		38,396			56,086
Building Lots		8,938			11,333
Other		431,227			490,345
Real estate construction		5,494			11,034
Residential mortgage		154,495			164,049
Consumer and home equity		71,363			77,822
Indirect consumer		24,146			29,588
Loans held for sale		7,367			6,388
		773,336			891,392
Less:
Net deferred loan origination fees		(257	)		(473	)
Allowance for loan losses		(16,018	)		(22,665	)
		(16,275	)		(23,138	)

Net Loans	$	757,061		$	868,254

The following table presents the activity in the allowance for loan losses by portfolio segment for the three and nine months ending September 30, 2011:

Three Months Ended
September 30, 2011				Commercial			Real Estate		Residential			Consumer &			Indirect
	Commercial			Real Estate			Construction		Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,371		$	14,133		$	95	$	702		$	690		$	717		$	17,708
Provision for loan losses		663			5,148			1		532			52			(272	)		6,124
Charge-offs		(814	)		(6,711	)		-		(206	)		(88	)		(51	)		(7,870	)
Recoveries		12			-			-		8			8			28			56
Total ending allowance balance	$	1,232		$	12,570		$	96	$	1,036		$	662		$	422		$	16,018

Nine Months Ended
September 30, 2011				Commercial			Real Estate			Residential			Consumer &			Indirect
	Commercial			Real Estate			Construction			Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,657		$	18,595		$	158		$	751		$	708		$	796		$	22,665
Provision for loan losses		460			18,217			(62	)		706			107			(322	)		19,106
Charge-offs		(956	)		(24,458	)		-			(429	)		(224	)		(138	)		(26,205	)
Recoveries		71			216			-			8			71			86			452
Total ending allowance balance	$	1,232		$	12,570		$	96		$	1,036		$	662		$	422		$	16,018

The following table presents the activity in the allowance for loan losses for the three and nine months ended September 30, 2010:

	Three Months Ended			Nine Months Ended
(Dollars in thousands)	September 30,			September 30,
	2010			2010

Balance, beginning of period	$	20,953		$	17,719
Provision for loan losses		6,327			11,353
Charge-offs		(7,276	)		(9,180	)
Recoveries		87			199
Balance, end of period	$	20,091		$	20,091

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4.	LOANS – (Continued)

We did not implement any changes to our 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 excluding loans held for sale and based on the impairment method as of September 30, 2011 and December 31, 2010:


September 30, 2011			Commercial		Real Estate		Residential		Consumer &		Indirect
	Commercial		Real Estate		Construction		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	541	$	3,380		-	$	498	$	131	$	24	$	4,574
Collectively evaluated for impairment		691		9,190		96		538		531		398		11,444

Total ending allowance balance	$	1,232	$	12,570		96	$	1,036	$	662	$	422	$	16,018

Loans:
Loans individually evaluated for impairment	$	3,961	$	79,098	$	-	$	1,768	$	228	$	143	$	85,198
Loans collectively evaluated for impairment		27,949		399,463		5,494		152,727		71,135		24,003		680,771
Loans acquired with deteriorated credit quality		-		-		-		-		-		-		-

Total ending loans balance	$	31,910	$	478,561	$	5,494	$	154,495	$	71,363	$	24,146	$	765,969

December 31, 2010			Commercial		Real Estate		Residential		Consumer &		Indirect
	Commercial		Real Estate		Construction		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	691	$	11,872		24	$	334	$	147	$	29	$	13,097
Collectively evaluated for impairment		966		6,723		134		417		561		767		9,568

Total ending allowance balance	$	1,657	$	18,595		158	$	751	$	708	$	796	$	22,665

Loans:
Loans individually evaluated for impairment	$	1,870	$	86,250	$	1,267	$	1,609	$	337	$	91	$	91,424
Loans collectively evaluated for impairment		42,877		471,514		9,767		162,440		77,485		29,497		793,580
Loans acquired with deteriorated credit quality		-		-		-		-		-		-		-

Total ending loans balance	$	44,747	$	557,764	$	11,034	$	164,049	$	77,822	$	29,588	$	885,004

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4.	LOANS – (Continued)

The following table presents loans individually evaluated for impairment by class of loans as of September 30, 2011 and December 31, 2010. The difference between the unpaid principal balance and recorded investment represents partial write downs/charge offs taken on individual impaired credits.

							Three Months Ended						Nine Months Ended
							September 30, 2011						September 30, 2011
September 30, 2011	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	$	3,198	$	3,198	$	-	$	3,156	$	158	$	158	$	1,722	$	81	$	81
Commercial Real Estate:
Land Development		17,016		10,948		-		11,980		353		353		8,639		192		192
Building Lots		3,662		1,305		-		653		7		7		326		1		1
Other		40,586		36,590		-		37,451		1,517		1,517		37,845		1,492		1,492
Real Estate Construction		-		-		-		499		-		-		368		13		13
Residential Mortgage		-		-		-		-		-		-		-		-		-
Consumer and Home Equity		-		-		-		-		-		-		-		-		-
Indirect Consumer		-		-		-		-		-		-		-		-		-

With an allowance recorded:
Commercial		763		763		541		876		44		44		1,243		59		59
Commercial Real Estate:
Land Development		2,952		2,952		442		1,885		55		55		9,810		218		218
Building Lots		477		477		265		1,066		12		12		2,248		9		9
Other		27,194		26,826		2,673		25,519		1,034		1,034		26,314		1,037		1,037
Real Estate Construction		-		-		-		-		-		-		271		9		9
Residential Mortgage		1,888		1,768		498		1,540		24		24		1,640		13		13
Consumer and Home Equity		228		228		131		238		-		-		278		-		-
Indirect Consumer		143		143		24		160		2		2		137		-		-

Total	$	98,107	$	85,198	$	4,574	$	85,023	$	3,206	$	3,206	$	90,841	$	3,124	$	3,124

December 31, 2010	Unpaid				Allowance for
	Principal		Recorded		Loan Losses
(Dollars in thousands)	Balance		Investment		Allocated

With no related allowance recorded:
Commercial	$	312	$	312	$	-
Commercial Real Estate:
Land Development		5,569		5,569		-
Building Lots		-		-		-
Other		34,327		32,332		-
Real Estate Construction		185		185		-
Residential Mortgage		-		-		-
Consumer and Home Equity		-		-		-
Indirect Consumer		-		-		-

With an allowance recorded:
Commercial		1,558		1,558		691
Commercial Real Estate:
Land Development		17,326		17,326		4,562
Building Lots		3,430		3,430		39
Other		27,593		27,593		7,271
Real Estate Construction		1,082		1,082		24
Residential Mortgage		1,609		1,609		334
Consumer and Home Equity		337		337		147
Indirect Consumer		91		91		29

Total	$	93,419	$	91,424	$	13,097

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4.	LOANS – (Continued)

The following table presents information for loans individually evaluated for impairment as of September 30, 2010:


	September 30,
(Dollars in thousands)	2010

Average of individually impaired loans during period		69,324
Interest income recognized during impairment		1,924
Cash-basis interest income recognized		1,924

The following table presents the recorded investment in restructured, nonaccrual and loans past due over 90 days still on accrual by class of loans as of September 30, 2011 and December 31, 2010.

					Loans Past Due
September 30, 2011					Over 90 Days
	Restructured on		Restructured on		Still
(Dollars in thousands)	Non-Accrual Status		Accrual Status		Accruing		Nonaccrual

Commercial	$	8	$	192		-	$	335
Commercial Real Estate:
Land Development		2,062		-		-		5,874
Building Lots		-		-		-		1,305
Other		20,892		4,972		-		19,306
Real Estate Construction		-		-		-		-
Residential Mortgage		340		305		-		967
Consumer and Home Equity		-		25		-		275
Indirect Consumer		-		-		-		93

Total	$	23,302	$	5,494		-	$	28,155


					Loans Past Due
December 31, 2010					Over 90 Days
	Restructured on		Restructured on		Still
(Dollars in thousands)	Non-Accrual Status		Accrual Status		Accruing		Nonaccrual

Commercial	$	-	$	179		-	$	597
Commercial Real Estate:
Land Development		-		-		-		15,356
Building Lots		-		-		-		3,430
Other		-		3,394		-		19,939
Real Estate Construction		-		-		-		-
Residential Mortgage		-		306		-		2,294
Consumer and Home Equity		-		27		-		365
Indirect Consumer		-		-		-		188

Total	$	-	$	3,906		-	$	42,169

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4.	LOANS – (Continued)

The following table presents the aging of the unpaid principal in past due loans as of September 30, 2011 and December 31, 2010 by class of loans:

September 30, 2011	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	$	1,447	$	215	$	1,112	$	2,774	$	29,136	$	31,910
Commercial Real Estate:
Land Development		3,362		-		4,352		7,714		30,682		38,396
Building Lots		-		477		1,305		1,782		7,156		8,938
Other		3,090		1,888		23,834		28,812		402,415		431,227
Real Estate Construction		-		-		-		-		5,494		5,494
Residential Mortgage		-		1,513		3,105		4,618		149,877		154,495
Consumer and Home Equity		1,555		265		537		2,357		69,006		71,363
Indirect Consumer		236		90		93		419		23,727		24,146

Total	$	9,690	$	4,448	$	34,338	$	48,476	$	717,493	$	765,969

December 31, 2010	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	$	719	$	683	$	574	$	1,976	$	42,771	$	44,747
Commercial Real Estate:
Land Development		-		-		7,682		7,682		48,404		56,086
Building Lots		-		-		3,430		3,430		7,903		11,333
Other		2,824		10,110		16,294		29,228		461,117		490,345
Real Estate Construction		1,082		-		-		1,082		9,952		11,034
Residential Mortgage		313		962		4,386		5,661		158,388		164,049
Consumer and Home Equity		527		70		680		1,277		76,545		77,822
Indirect Consumer		386		51		188		625		28,963		29,588

Total	$	5,851	$	11,876	$	33,234	$	50,961	$	834,043	$	885,004

Troubled Debt Restructurings:

We have allocated $1.6 million and $151,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2011 and December 31, 2010. 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 period ending September 30, 2011, 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.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4.	LOANS – (Continued)

The following table presents loans by class modified as troubled debt restructurings that occurred during the period ending September 30, 2011:

	Three Months Ended						Nine Months Ended
	September 30, 2011						September 30, 2011
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
September 30, 2011			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		-		-		-		1		3,223		2,062
Building Lots		-		-		-		-		-		-
Other		2		1,550		1,547		7		24,792		22,818
Real Estate Construction		-		-		-		-		-		-
Residential Mortgage		-		-		-		1		444		340
Consumer and Home Equity		-		-		-		-		-		-
Indirect Consumer		-		-		-		-		-		-

Total		2	$	1,550	$	1,547		9	$	28,459	$	25,220

The troubled debt restructurings described above increased the allowance for loan losses by $1.6 million and resulted in charge offs of $2.5 million and $3.4 million for the three and nine month periods ending September 30, 2011.

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the period ending September 30, 2011:

September 30, 2011
	Number		Recorded
(Dollars in thousands)	of Loans		Investment

Troubled Debt Restructurings:
Commercial		1	$	8
Commercial Real Estate:
Land Development		-		-
Building Lots		-		-
Other		2		5,300
Real Estate Construction		-		-
Residential Mortgage		1		340
Consumer and Home Equity		-		-
Indirect Consumer		-		-

Total		4	$	5,648

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 $13,000 and resulted in charge offs of $2.5 million and $2.6 million for the three and nine month periods ending September 30, 2011.

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.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4.	LOANS – (Continued)

As of September 30, 2011 and December 31, 2010, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

September 30, 2011
(Dollars in thousands)	Not Rated		Pass		Criticized		Substandard		Doubtful		Loss		Total

Commercial	$	-	$	26,177	$	1,772	$	3,616	$	345	$	-	$	31,910
Commercial Real Estate:
Land Development		-		18,998		5,498		13,900		-		-		38,396
Building Lots		-		6,595		561		1,782		-		-		8,938
Other		-		349,512		8,748		72,967		-		-		431,227
Real Estate Construction		-		5,494		-		-		-		-		5,494
Residential Mortgage		148,560		-		575		5,360		-		-		154,495
Consumer and Home Equity		69,559		-		730		1,074		-		-		71,363
Indirect Consumer		23,818		-		9		319		-		-		24,146

Total	$	241,937	$	406,776	$	17,893	$	99,018	$	345	$	-	$	765,969

December 31, 2010
(Dollars in thousands)	Not Rated		Pass		Criticized		Substandard		Doubtful		Loss		Total

Commercial	$	-	$	40,518	$	2,359	$	1,412	$	458	$	-	$	44,747
Commercial Real Estate:
Land Development		-		29,769		3,422		22,895		-		-		56,086
Building Lots		-		7,903		-		3,430		-		-		11,333
Other		-		409,387		21,012		59,800		125		21		490,345
Real Estate Construction		-		9,767		-		1,267		-		-		11,034
Residential Mortgage		157,572		-		917		5,560		-		-		164,049
Consumer and Home Equity		76,127		-		599		1,072		-		24		77,822
Indirect Consumer		29,342		-		-		227		-		19		29,588

Total	$	263,041	$	497,344	$	28,309	$	95,663	$	583	$	64	$	885,004

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, 2011 and December 31, 2010:

September 30, 2011	Residential		Consumer &		Indirect
(Dollars in thousands)	Mortgage		Home Equity		Consumer

Performing	$	152,883	$	71,063	$	24,053
Restructured & Non-accrual		1,612		300		93

Total	$	154,495	$	71,363	$	24,146

December 31, 2010	Residential		Consumer &		Indirect
(Dollars in thousands)	Mortgage		Home Equity		Consumer

Performing	$	161,449	$	77,430	$	29,400
Restructured & Non-accrual		2,600		392		188

Total	$	164,049	$	77,822	$	29,588

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

5.	REAL ESTATE ACQUIRED THROUGH FORECLOSURE

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

	Nine Months Ended			Year Ended
	September 30,			December 31,
(Dollars in thousands)	2011			2010

Beginning balance	$	25,807		$	8,428
Additions		16,140			24,622
Sales		(4,845	)		(4,928	)
Writedowns		(7,922	)		(2,315	)
Ending balance	$	29,180		$	25,807

6.	INCOME TAXES

The calculation for the income tax provision or benefit generally does not consider the tax effects of changes in other comprehensive income, or OCI, which is a component of shareholders’ equity on the balance sheet. However, an exception is provided in certain circumstances, such as when there is a full valuation allowance against net deferred tax assets, there is a loss from continuing operations and income in other components of the financial statements. In such a case, pre-tax income from other categories, such as changes in OCI, must be considered in determining a tax benefit to be allocated to the loss from continuing operations. For the nine month period ended September 30, 2011, this resulted in $3.3 million of income tax benefit allocated to continuing operations.

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 various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010 and 2011. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at September 30, 2011 and December 31, 2010.

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
(Dollars in thousands,	September 30,						September 30,
except per share data)	2011			2010			2011			2010

Basic:
Net income/(loss)	$	(7,436	)	$	(2,493	)	$	(21,410	)	$	(1,801	)
Less:
Preferred stock dividends		(250	)		(250	)		(750	)		(750	)
Accretion on preferred stock discount		(14	)		(14	)		(41	)		(41	)
Net income (loss) available to common shareholders	$	(7,700	)	$	(2,757	)	$	(22,201	)	$	(2,592	)
Weighted average common shares		4,747			4,724			4,741			4,720

Diluted:
Weighted average common shares		4,747			4,724			4,741			4,720
Dilutive effect of stock options and warrants		-			-			-			-
Weighted average common and incremental shares		4,747			4,724			4,741			4,720

Earnings (Loss) Per Common Share:
Basic	$	(1.62	)	$	(0.58	)	$	(4.68	)	$	(0.55	)
Diluted	$	(1.62	)	$	(0.58	)	$	(4.68	)	$	(0.55	)

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

7.	EARNINGS (LOSS) PER SHARE – (Continued)

Stock options for 258,021 shares of common stock were not included in the September 30, 2011 computation of diluted earnings per share for the quarter and year to date because their impact was anti-dilutive. Stock options for 235,021 shares of common stock were not included in the September 30, 2010 computation of diluted earnings per share for the quarter and year to date because their impact was anti-dilutive. Warrants to purchase 215,983 shares at September 30, 2011 and 2010 were not included in the computation because their impact was also anti-dilutive.

8.	STOCK BASED COMPENSATION PLAN

Our 2006 Stock Option and Incentive Compensation Plan, which is shareholder approved, succeeded our 1998 Stock Option and Incentive Compensation Plan. Under the 2006 Plan, we may grant restricted stock and incentive or non-qualified stock options to key employees and directors for a total of 647,350 shares of our common stock. Options available for future grants under the 1998 Plan totaled 38,500 shares and were rolled into the 2006 Plan. 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 shareholders by providing awards intended to reward recipients for our long-term growth. Options to purchase shares 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 again become available for option or award for the purposes of the Plan. At September 30, 2011, options and restricted stock available for future grants under the 2006 Plan totaled 469,059.

Compensation cost related to options and restricted stock granted under the 1998 and 2006 Plans that was charged against earnings for the nine month periods ended September 30, 2011 and 2010 was $143,000 and $71,000. As of September 30, 2011 there was $281,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 1998 and 2006 Plans. That cost is expected to be recognized over a weighted-average period of 2.5 years.

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. There were no stock option grants for the September 30, 2011 period.

A summary of option activity under the 1998 and 2006 Plans as of September 30, 2011 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		296,521		$	13.70
Granted during period		-			-
Forfeited during period		(38,500	)		14.09
Exercised during period		-			-
Outstanding, end of period		258,021		$	13.65		6.3	$	-

Eligible for exercise at period end		122,455		$	19.26		4.1	$	-

There were no options exercised, modified or settled in cash for the periods ended September 30, 2011 and 2010. Management expects all outstanding unvested options will vest.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

8.	STOCK BASED COMPENSATION PLAN – (Continued)

Restricted Stock – In addition to stock options, on December 31, 2010, we granted 36,855 shares of restricted common stock at the weighted average current market price of $4.07. No restricted stock had been granted prior to December 31, 2010. Restricted stock provides the grantee with voting, dividend and anti-dilution rights equivalent to common shareholders. The restricted stock vests on December 31, 2012, provided that the recipient has continued to perform substantial services for the Company through that date. The restricted stock will become 100% vested before the vesting date upon the recipient’s death or disability or a change of control event as defined by federal regulations. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date of vesting. The recipient may not transfer, pledge or dispose of the restricted stock before the date of vesting, and thereafter only in proportion to percentage of the preferred shares originally issued to the U.S. Treasury that have been redeemed. As of September 30, 2011 there was $94,000 of total unrecognized compensation cost related to the restricted stock. That cost is expected to be recognized over the remaining vesting period of 1.25 years.

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 of available-for-sale-securities.

Securities: The fair values of some equity securities are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs). The fair values of most debt securities are 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). In certain cases where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. For trust preferred securities, discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations. For other equity securities, discounted cash flows are calculated with available market information through processes using benchmark yields, market spreads sourced from new issues, dealer quotes and trade prices among other sources. Equity securities are carried at cost which approximates fair value.

Impaired Loans: The fair value of impaired loans with specific allocations of the allowance for loan losses is generally 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.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9.	FAIR VALUE - (Continued)

Other Real Estate Owned: Nonrecurring adjustments to certain commercial and residential real estate properties classified as other real estate owned are measured at fair value, less costs to sell. Fair values are based on recent real estate appraisals. These appraisals may use 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.

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 significant 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)	2011		(Level 1)		(Level 2)		(Level 3)

Assets:
U.S. Treasury and agencies	$	52,076	$	-	$	52,076	$	-
Government-sponsored mortgage-backed residential		255,764		-		255,764		-
Equity		293		2		-		291
State and municipal		23,851		-		23,851		-
Trust preferred securities		373		-		-		373

Total	$	332,357	$	2	$	331,691	$	664

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2010		(Level 1)		(Level 2)		(Level 3)

Assets:
U.S. Treasury and agencies	$	113,893	$	-	$	113,893	$	-
Government-sponsored mortgage-backed residential		59,170		-		59,170		-
Equity		293		2		-		291
State and municipal		22,618		-		22,618		-
Trust preferred securities		55		-		-		55

Total	$	196,029	$	2	$	195,681	$	346

Between June 2002 and July 2006, we invested in four available-for-sale and one held-to-maturity investment grade tranches of trust preferred collateralized debt obligation (“CDO”) securities. The securities were issued and are referred to as Preferred Term Securities Limited (“PreTSL”). The underlying collateral for the PreTSL is unguaranteed pooled trust preferred securities issued by banks, insurance companies and REITs geographically dispersed across the United States. We hold five PreTSL securities, none of which are currently investment grade. Prior to September 30, 2008, we determined the fair value of the trust preferred securities using a valuation technique based on Level 2 inputs. The Level 2 inputs included estimates of the market value for each security provided through our investment broker.

Since late 2007, the markets for collateralized debt obligations and trust preferred securities have become increasingly inactive. The inactivity began in late 2007 when new issues of similar securities were discounted in order to complete the offering. Beginning in the second quarter of 2008, the purchase and sale activity of these securities substantially decreased as investors elected to hold the

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9.	FAIR VALUE - (Continued)

securities instead of selling them at substantially depressed prices. Our brokers have indicated that little if any activity is occurring in this sector and that the PreTSL securities trades that are taking place are primarily distressed sales where the seller must liquidate as a result of insolvency, redemptions or closure of a fund holding the security, or other distressed conditions. As a result, the bid-ask spreads have widened significantly and the volume of trades decreased significantly compared to historical volumes.

During 2008, we concluded that the market for the trust preferred securities that we hold and for similar CDO securities (such as higher-rated tranches within the same CDO security) was also not active. That determination was made considering that there are few observable transactions for the trust preferred securities or similar CDO securities and the observable prices for those transactions have varied substantially over time. Consequently, we have considered those observable inputs and determined that our trust preferred securities are classified within Level 3 of the fair value hierarchy.

We have determined that an income approach valuation technique (using cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs is equally or more representative of fair value than relying on the estimation of market value technique used at prior measurement dates, which now has few observable inputs and relies on an inactive market with distressed sales conditions that would require significant adjustments.

We received valuation estimates on our trust preferred securities for September 30, 2011. Those valuation estimates were based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market. In accordance with current accounting guidance, we determined that a risk-adjusted discount rate appropriately reflects the reporting entity’s estimate of the assumptions that market participants would use in an active market to estimate the selling price of the asset at the measurement date.

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 reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended September 30, 2011 and 2010:

	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)	2011			2010			2011			2010

Beginning balance	$	668		$	334		$	346		$	340
Total gains or losses:
Impairment charges on securities		(58	)		(649	)		(83	)		(782	)
Included in other comprehensive income		54			667			401			794
Transfers in and/or out of Level 3		-			-			-			-
Ending balance	$	664		$	352		$	664		$	352

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9.	FAIR VALUE - (Continued)

The table below summarizes changes in unrealized gains and losses recorded in earnings for the quarter and nine months ended September 30 for Level 3 assets and liabilities that are still held at September 30.

	Changes in Unrealized Gains/Losses				Changes in Unrealized Gains/Losses
	Relating to Assets Still Held at Reporting				Relating to Assets Still Held at Reporting
	Date for the Three Months Ended				Date for the Nine Months Ended
	September 30,				September 30,
(Dollars in thousands)	2011		2010		2011		2010

Interest income on securities	$	-	$	-	$	-	$	-
Other changes in fair value		58		649		83		782
Total	$	58	$	649	$	83	$	782

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)	2011		(Level 1)		(Level 2)		(Level 3)

Assets:
Impaired loans:
Commercial	$	3,273	$	-	$	-	$	3,273
Commercial Real Estate:
Land Development		11,396		-		-		11,396
Building Lots		1,517		-		-		1,517
Other		36,430		-		-		36,430
Real Estate Construction		-		-		-		-
Residential Mortgage		4,127		-		-		4,127
Consumer and Home Equity		833		-		-		833
Indirect Consumer		260		-		-		260
Real estate acquired through foreclosure:
Commercial		959		-		-		959
Commercial Real Estate:
Land Development		2,684		-		-		2,684
Building Lots		5,575		-		-		5,575
Other		6,881		-		-		6,881
Residential Mortgage		221		-		-		221
Trust preferred security held-to-maturity		23		-		-		23

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2010		(Level 1)		(Level 2)		(Level 3)

Assets:
Impaired loans:
Commercial	$	1,092	$	-	$	-	$	1,092
Commercial Real Estate:
Land Development		18,333		-		-		18,333
Building Lots		3,391		-		-		3,391
Other		49,505		-		-		49,505
Real Estate Construction		1,057		-		-		1,057
Residential Mortgage		4,821		-		-		4,821
Consumer and Home Equity		824		-		-		824
Indirect Consumer		171		-		-		171
Real estate acquired through foreclosure
Commercial		1,103		-		-		1,103
Commercial Real Estate:
Land Development		2,190		-		-		2,190
Building Lots		1,483		-		-		1,482
Other		3,375		-		-		3,375
Residential Mortgage		428		-		-		428
Trust preferred security held-to-maturity		22		-		-		22

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 $61.0 million, with a valuation allowance of $3.2 million, resulting in an additional provision for loan losses of $4.1 million and $12.8 million for the three and nine month periods ended September 30, 2011. Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisals 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 investor’s 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.

Our held-to-maturity trust preferred security is valued using an income approach valuation technique (using cash flows and present value techniques) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs. The income approach is equally or more representative of fair value than relying on the estimation of market value technique used at prior measurement dates, which now has few observable inputs and relies on an inactive market with distressed sales conditions that would require significant adjustments.

We received a valuation estimate on our trust preferred security for September 30, 2011. The valuation estimate was based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market.

Fair Value of Financial Instruments

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

(Dollars in thousands)	September 30, 2011				December 31, 2010
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Financial assets:
Cash and due from banks	$	33,948	$	33,948	$	166,176	$	166,176
Securities held-to-maturity		-		-		102		104
Loans held for sale		7,367		7,466		6,388		6,472
Loans, net		691,858		705,253		782,672		792,486
Accrued interest receivable		3,268		3,268		3,807		3,807
FHLB stock		4,805		N/A		4,909		N/A

Financial liabilities:
Deposits		1,108,400		1,122,077		1,173,908		1,163,654
Advances from Federal Home Loan Bank		27,770		31,068		52,532		55,190
Subordinated debentures		18,000		12,743		18,000		12,743
Accrued interest payable		1,476		1,476		594		594

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9.	FAIR VALUE - (Continued)

The methods and assumptions used in estimating fair value disclosures for financial instruments are presented below:

Carrying amount is the estimated fair value for cash and cash equivalents, interest bearing deposits, accrued interest receivable and payable, demand deposits, short-term debt and variable rate loans or deposits that re-price frequently and fully. Held-to-maturity securities fair values are based on market prices or dealer quotes and if no such information is available, on the rate and term of the security and information about the issuer. The value of loans held for sale is based on the underlying sale commitments. For fixed rate loans or deposits and for variable rate loans or deposits with infrequent re-pricing or re-pricing limits, fair value is based on discounted cash flows using current market rates applied to the estimated life. Fair values of advances from Federal Home Loan Bank and subordinated debentures are based on current rates for similar financing. The fair value of off-balance-sheet items is based on the current fees or cost that would be charged to enter into or terminate such arrangements and is not material. It is not practicable to determine the fair value of FHLB stock due to restrictions placed on its transferability.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

10.	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 annum for the first five years and will reset to a rate of 9% per annum after five years. The Senior Preferred Shares may be redeemed at any time, at our option. We also have the ability to defer dividend payments at any time, at our option.

We also issued a warrant to purchase 215,983 common shares to the U.S. Treasury at a purchase price of $13.89 per share. The aggregate purchase price equals 15% of the aggregate amount of the Senior Preferred Shares purchased by the U.S. Treasury, which was $3 million. The initial purchase price per share for the warrant and the number of common shares subject to the warrant were determined by reference to the market price of the common shares (calculated on a 20-day trailing average) on December 8, 2008, the date the U.S. Treasury approved our TARP application. The warrant has a term of 10 years and is potentially dilutive to earnings per share.

On October 29, 2010, we gave written notice to the U.S. Treasury that effective with the fourth quarter of 2010, we were suspending the payment of regular quarterly cash dividends on our Senior Preferred Shares. Under the CPP provisions, failure to pay dividends for six quarters would trigger the right of the holder of our Senior Preferred Shares to appoint representatives to our Board of Directors. The dividends 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. As of September 30, 2011, these accrued but unpaid dividends totaled $1.1 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 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 earlier of three years or such time that the preferred shares are redeemed.

On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was enacted. As required by ARRA, the U.S. Treasury has issued additional compensation standards on companies receiving financial assistance from the U.S. government. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on each CPP recipient, until the recipient has repaid the Treasury. ARRA also permits CPP participants to redeem the preferred shares held by the Treasury Department without penalty and without the need to raise new capital, subject to the Treasury’s consultation with the recipient’s appropriate regulatory agency.

11.	STOCKHOLDERS’ EQUITY

Regulatory Capital Requirements – The Corporation and the Bank are subject to regulatory capital requirements 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 initiate 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.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

11.	STOCKHOLDERS’ EQUITY - (Continued)

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 I capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier I 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".

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

(Dollars in thousands)						For Capital
	Actual					Adequacy Purposes
	Amount		Ratio			Amount		Ratio
As of September 30, 2011:
Total risk-based capital (to risk-weighted assets)
Consolidated	$	81,970		9.68	%	$	67,742		8.00	%
Bank		84,138		9.94			67,691		8.00
Tier I capital (to risk-weighted assets)
Consolidated		71,318		8.42			33,871		4.00
Bank		73,485		8.68			33,845		4.00
Tier I capital (to average assets)
Consolidated		71,318		5.79			49,307		4.00
Bank		73,485		5.95			49,370		4.00

											To Be Considered
											Well Capitalized
											Under Prompt
(Dollars in thousands)						For Capital					Correction
	Actual					Adequacy Purposes					Action Provisions
	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of December 31, 2010:
Total risk-based capital (to risk-weighted assets)
Consolidated	$	104,717		11.34	%	$	73,890		8.00	%		N/A		N/A
Bank		105,116		11.38			73,880		8.00			92,350		10.00
Tier I capital (to risk-weighted assets)
Consolidated		93,034		10.07			36,945		4.00			N/A		N/A
Bank		93,423		10.12			36,940		4.00			55,410		6.00
Tier I capital (to average assets)
Consolidated		93,034		7.16			52,003		4.00			N/A		N/A
Bank		93,423		7.18			52,082		4.00			65,103		5.00

In the Consent Order, a formal agreement with the FDIC and KDFI, the Bank agreed to achieve and maintain the capital ratios set forth in the following table: At March 31, June 30, and September 30, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements.

				Ratio Required
	Actual as of			by the Order
	9/30/2011			at 6/30/2011
Total capital to risk-weighted assets		9.94	%		12.00	%
Tier 1 capital to average total assets		5.95	%		9.00	%

Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

GENERAL

We operate 22 full-service banking centers and a commercial private banking center in eight contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area, including southern Indiana. 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 to Harrison County, Indiana approximately 60 miles northwest of our headquarters. 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 and in Harrison and Floyd counties in southern Indiana.

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 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, and collateralized mortgage obligations.

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 and provisions for loan losses.

The discussion and analysis section covers material changes in the financial condition since December 31, 2010 and material changes in the results of operations for the three and nine month periods ending September 30, 2011 as compared to the corresponding periods of 2010. 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, 2010, as amended by Form 10-K/A filed May 13, 2011.

OVERVIEW

The unfavorable economic conditions that have persisted since 2007 continued to significantly impact the banking industry and our performance during the first nine months of 2011. We are currently working through this credit cycle. During 2011 we continued to experience an increase in our non-performing assets. We have adjusted our policies, procedures and resources to address these dynamic situations. Our loan policy has been revised to support our focus on reducing our concentration in real estate and our focus to diversify lending. We established a board loan committee to meet weekly to address loan approvals and renewals, loan workout situations and the disposal of large other real estate owned assets. We also added personnel to concentrate on working with struggling borrowers, work on more efficient asset resolutions, and strengthen the management of other real estate owned. A new appraisal policy was implemented regarding management procedures surrounding the appraisal process. In accordance with our credit management processes, we obtain new appraisals on properties securing our non-performing 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. Our decline in credit quality impacted our results during 2011 in the areas of net interest income, provision for loan losses, non-interest income, non-interest expense, and reversals of tax benefits.

Our net loss attributable to common shareholders for the quarter ended September 30, 2011 was $7.7 million or $1.62 per diluted common share compared to net loss attributable to common shareholders of $2.8 million or $.58 per diluted common share for the same period in 2010. Our net loss attributable to common shareholders for the nine month period ended September 30, 2011 was $22.2 million or $4.68 per diluted common share compared to a net loss of $2.6 million or $.55 per diluted common share for the same period a year ago. The nine month 2011 results include provision for loans losses of $19.1 million, write downs and losses on other real estate owned of $8.2 million, an increase in FDIC insurance expense of $586,000, and other than temporary securities impairment of $168,000.

Our non-performing assets are largely comprised of residential housing development assets, building lots, an office building and strip centers primarily located in Jefferson and Oldham Counties. Non-performing assets increased to $86.2 million or 7.04% of total assets compared to $71.9 million or 5.45% of total assets at December 31, 2010. During 2011, we have had substantially all of our non-performing assets appraised or reappraised, including our high end residential development loans and related other real estate owned. The lower values on the appraisals and reviews of properties appraised within the past year contributed to $19.1 million in provision expense and $7.9 million in write downs on other real estate owned recorded for the year. We believe that we have been aggressive in writing down real estate values the past two quarters to levels that have a higher probability of liquidation. We also believe we have appropriately addressed and risk-weighted real estate loans in our portfolio. While deterioration in the portfolio is expected to continue, we believe it will be at a slower pace than the accelerated pace from the past eight quarters.

The allowance to total loans was 2.09% at September 30, 2011 while net charge-offs totaled 411 basis points, annualized, for the first nine months of 2011, compared to 124 basis points, annualized, for the same nine month period in 2010. Non-performing loans were $57.0 million, or 7.44% of total loans at September 30, 2011 compared to $46.1 million, or 5.21% of total loans for December 31, 2010. The allowance for loan losses to non-performing loans was 28% at September 30, 2011 compared to 49% at December 31, 2010. The decline in the coverage ratio was due to the charge-off of specific reserves of which $8.7 million was previously reserved for at December 31, 2010, as well as the increase in restructured loans.

Net interest income was $24.8 million for the nine month 2011 period compared to $27.5 million for the same 2010 period, while the net interest margin was 2.84% for 2011 compared to 3.14% in 2010. The net interest margin was negatively impacted by a higher level of non-performing assets, a decline in average loan balances outstanding, and our efforts to increase liquidity by placing assets into lower yielding investments other than loans. Non-interest income decreased $7.4 million for the nine months ended September 30, 2011, primarily driven by an increase of $7.4 million in the loss on sale and write downs on real estate acquired through foreclosure. Non-interest expense increased $3.7 million to $29.4 million for the 2011 nine month period compared to the 2010 nine month period. Outside services expense increased due to expenses incurred in connection with loan workout activities and the addition of loan workout specialists to our staff. FDIC insurance premiums increased $586,000 due to the higher FDIC insurance rate resulting from the Bank’s regulatory rating. Expense related to real estate acquired through foreclosure increased $588,000 due to the higher level of properties in this portfolio at September 30, 2011. Other expense increased due to increases in interchange expense, legal fees and loan portfolio management expenses such as the cost of obtaining new appraisals on real estate securing some of our commercial real estate loans. The increase in loan expense reflects our elevated level of non-performing loans.

As a result of the Consent Order entered into between the FDIC, KDFI and the Bank, the Bank is categorized as a "troubled institution" by bank regulators, which by definition does not permit the Bank to be considered "well-capitalized.”

In its Consent Order with the FDIC and KDFI, the Bank has agreed to achieve and maintain a Tier 1 leverage ratio of 8.5% and a total risk-based capital ratio of 11.5% by March 31, 2011 and achieve and maintain a Tier 1 leverage ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2011. At March 31, June 30, and September 30, 2011, we were not in compliance with the Tier 1 and total risk-based capital requirements. We notified the bank regulatory agencies that the increased capital levels would not be achieved and anticipate that the FDIC and KDFI will reevaluate our progress toward achieving the higher capital ratios at March 31, 2012.

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

In order to meet these capital requirements, we have engaged an investment banking firm with expertise in the financial services sector to assist with a review of strategic opportunities available to us. We continue reducing our costs where possible while taking into consideration the resources necessary to execute our strategies. We have suspended the annual employee stock ownership contribution, frozen executive management compensation the past three years and into 2012, frozen officer compensation for the past year and into 2012, eliminated board of director fees, reduced marketing expenses, reduced community donation expense, reduced compensation expense by $500,000 through reductions in associates, and implemented various other cost savings initiatives. Expense reductions for 2011 were estimated to be $1.2 million. Additional cost reductions for 2012 are projected to be in excess of $1.0 million. We are also evaluating remaining terms on existing contracts and identifying expenses we cannot reduce currently, but expect to be able to in 2012 and 2013, such as FDIC insurance, examination fees and loan workout and other real estate owned expenses. These efforts will remain ongoing.

Our plans for the fourth quarter of 2011 include the following:

While our concerns about economic conditions in our market continue, we are working towards our long-range financial 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 Allowance for Loan Loss Review Committee, which is comprised of senior officers and certain accounting associates, evaluate 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 or loans otherwise classified as substandard or doubtful. The general component covers non-classified loans and is based on historical loss experience 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.

Based on our calculation, an allowance of $16.0 million or 2.09% of total loans was our estimate of probable incurred losses within the loan portfolio as of September 30, 2011. This estimate required us to record a provision for loan losses on the income statement of $19.1 million for the 2011 nine month 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 fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. 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 by the selling cost. We have dedicated a team of associates and management to the resolution and work out of other real estate owned as it has become a larger portion of our assets and a larger area of our risk. 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. Valuation allowances are established when necessary to reduce deferred tax assets to an amount 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 tax provision in the period for which the credits may be utilized.

In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010 and 2011. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at September 30, 2011 and December 31, 2010.

RESULTS OF OPERATIONS

Net loss attributable to common shareholders for the quarter ended September 30, 2011 was $7.7 million or $1.62 per diluted common share compared to net loss attributable to common shareholders of $2.8 million or $.58 per diluted common share for the same period in 2010. Net loss attributable to common shareholders for the nine month period ended September 30, 2011 was $22.2 million or $4.68 per diluted common share compared to a net loss of $2.6 million or $.55 per diluted common share for the same period a year ago. Contributing to the net loss for 2011 were a decrease in our net interest margin, an increase of $7.8 million in the provision for loan losses, a valuation allowance against deferred tax assets of $9.0 million, write downs taken on real estate acquired through foreclosure, higher FDIC insurance premiums, and a higher level of other non-interest expense. Net loss attributable to common shareholders was also impacted by dividends accrued on preferred shares. Our book value per common share decreased from $13.79 at September 30, 2010 to $7.69 at September 30, 2011.

Net Interest Income – The principal source of our revenue is net interest income. Net interest income is the difference between interest income on interest-earning assets, such as loans and securities and the interest expense on liabilities used to fund those assets, such as interest-bearing deposits and borrowings. Net interest income is affected by both changes in the amount and composition of interest-earning assets and interest-bearing liabilities as well as changes in market interest rates.

The large decline in the volume of interest earning assets for the quarter and the change in the mix of interest earning assets caused a negative impact on net interest income, which decreased $1.2 million and $2.7 million for the three and nine month 2011 periods compared to the prior year periods. Average interest earning assets decreased $40.9 million for the 2011 quarter compared to 2010 due to a decrease in average loans and our efforts to increase liquidity by increasing lower yielding investments. The decrease in average loans was due to loan principal payments, payoffs, charge-offs and the conversion of nonperforming loans to other real estate owned properties. Average loan yields were 5.44% and 5.57% for the three and nine month 2011 periods compared to average loan yields of 5.69% and 5.79% for the 2010 periods.

The shift in the mix of assets resulting from the addition of lower yielding assets and the increase in the amount of non-performing assets also negatively impacted our net interest margin. The yield on earning assets averaged 4.50% and 4.62% for the three and nine month 2011 periods compared to an average yield on earning assets of 5.00% and 5.10% for the 2010 periods. This decrease was offset somewhat by a decrease in our cost of funds. Net interest margin as a percent of average earning assets decreased 31 basis points to 2.76% for the quarter ended September 30, 2011 and 30 basis points to 2.84% for the nine months ended September 30, 2011 compared to 3.07% and 3.14% for the 2010 periods.

Our cost of funds averaged 1.83% and 1.90% for the quarter and nine month 2011 periods compared to an average cost of funds of 2.10% and 2.14% for the same periods in 2010. Going forward, we expect market short-term interest rates to remain low for an extended period of time. Continued re-pricing of variable rate loans and our efforts to increase liquidity by increasing lower yielding investments other than loans is likely to compress our net interest margin in future quarters.

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,
	2011								2010
(Dollars in thousands)	Average					Average			Average					Average
	Balance			Interest		Yield/Cost (5)			Balance			Interest		Yield/Cost (5)

ASSETS
Interest earning assets:
U.S. Treasury and agencies	$	81,324		$	192		0.94	%	$	78,358		$	486		2.46	%
Mortgage-backed securities		191,957			1,511		3.12			47,240			454		3.81
Equity securities		294			10		13.49			382			12		12.46
State and political subdivision securities (1)		23,171			401		6.87			22,925			387		6.70
Corporate bonds		1,109			17		6.08			1,910			27		5.61
Loans (2) (3) (4)		790,674			10,844		5.44			944,861			13,543		5.69
FHLB stock		4,805			52		4.29			6,558			91		5.51
Interest bearing deposits		59,379			34		0.23			91,356			47		0.20
Total interest earning assets		1,152,713			13,061		4.50			1,193,590			15,047		5.00
Less: Allowance for loan losses		(16,471	)							(20,342	)
Non-interest earning assets		97,210								84,050
Total assets	$	1,233,452							$	1,257,298

LIABILITIES AND STOCKHOLDERS' EQUITY
Interest bearing liabilities:
Savings accounts	$	89,375		$	90		0.40	%	$	105,843		$	218		0.82	%
NOW and money market accounts		290,770			564		0.77			273,120			751		1.09
Certificates of deposit and other time deposits		667,343			3,775		2.24			648,647			3,914		2.39
Short term borrowings		-			-		-			429			6		5.55
FHLB advances		27,783			282		4.03			52,575			599		4.52
Subordinated debentures		18,000			342		7.54			18,000			331		7.30
Total interest bearing liabilities		1,093,271			5,053		1.83			1,098,614			5,819		2.10
Non-interest bearing liabilities:
Non-interest bearing deposits		77,018								69,671
Other liabilities		3,399								3,252
Total liabilities		1,173,688								1,171,537

Stockholders' equity		59,764								85,761
Total liabilities and stockholders' equity	$	1,233,452							$	1,257,298

Net interest income				$	8,008							$	9,228
Net interest spread							2.67	%							2.90	%
Net interest margin							2.76	%							3.07	%

(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

	Nine Months Ended September 30,
	2011								2010
(Dollars in thousands)	Average					Average			Average					Average
	Balance			Interest		Yield/Cost (5)			Balance			Interest		Yield/Cost (5)

ASSETS
Interest earning assets:
U.S. Treasury and agencies	$	111,162		$	1,772		2.13	%	$	57,351		$	1,113		2.59	%
Mortgage-backed securities		119,883			2,898		3.23			28,776			857		3.98
Equity securities		294			31		14.10			571			47		11.01
State and political subdivision securities (1)		22,925			1,192		6.95			19,450			952		6.54
Corporate bonds		1,105			52		6.29			1,929			74		5.13
Loans (2) (3) (4)		836,808			34,879		5.57			965,978			41,857		5.79
FHLB stock		4,866			158		4.34			7,863			275		4.68
Interest bearing deposits		93,060			174		0.25			104,484			122		0.16
Total interest earning assets		1,190,103			41,156		4.62			1,186,402			45,297		5.10
Less: Allowance for loan losses		(21,037	)							(18,822	)
Non-interest earning assets		98,914								82,971
Total assets	$	1,267,980							$	1,250,551

LIABILITIES AND STOCKHOLDERS' EQUITY
Interest bearing liabilities:
Savings accounts	$	107,856		$	433		0.54	%	$	116,571		$	684		0.78	%
NOW and money market accounts		284,613			1,841		0.86			262,838			2,250		1.14
Certificates of deposit and other time deposits		681,476			11,744		2.30			642,049			11,708		2.44
Short term borrowings		-			-		-			698			38		7.28
FHLB advances		28,005			857		4.09			52,624			1,788		4.54
Subordinated debentures		18,000			1,032		7.67			18,000			989		7.35
Total interest bearing liabilities		1,119,950			15,907		1.90			1,092,780			17,457		2.14
Non-interest bearing liabilities:
Non-interest bearing deposits		76,440								67,801
Other liabilities		3,202								3,724
Total liabilities		1,199,592								1,164,305

Stockholders' equity		68,388								86,246
Total liabilities and stockholders' equity	$	1,267,980							$	1,250,551

Net interest income				$	25,249							$	27,840
Net interest spread							2.72	%							2.96	%
Net interest margin							2.84	%							3.14	%

(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

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,
	2011 vs. 2010									2011 vs. 2010
	Increase (decrease)									Increase (decrease)
	Due to change in									Due to change in
(Dollars in thousands)							Net									Net
	Rate			Volume			Change			Rate			Volume			Change
Interest income:
U.S. Treasury and agencies	$	(312	)	$	18		$	(294	)	$	(229	)	$	888		$	659
Mortgage-backed securities		(96	)		1,153			1,057			(190	)		2,231			2,041
Equity securities		1			(3	)		(2	)		11			(27	)		(16	)
State and political subdivision securities		10			4			14			62			178			240
Corporate bonds		2			(12	)		(10	)		15			(37	)		(22	)
Loans		(564	)		(2,135	)		(2,699	)		(1,547	)		(5,431	)		(6,978	)
FHLB stock		(18	)		(21	)		(39	)		(18	)		(99	)		(117	)
Interest bearing deposits		5			(18	)		(13	)		66			(14	)		52

Total interest earning assets		(972	)		(1,014	)		(1,986	)		(1,830	)		(2,311	)		(4,141	)

Interest expense:
Savings accounts		(98	)		(30	)		(128	)		(203	)		(48	)		(251	)
NOW and money market accounts		(233	)		46			(187	)		(584	)		175			(409	)
Certificates of deposit and other time deposits		(250	)		111			(139	)		(662	)		698			36
Short term borrowings		(4	)		(2	)		(6	)		(10	)		(28	)		(38	)
FHLB advances		(60	)		(257	)		(317	)		(163	)		(768	)		(931	)
Subordinated debentures		11			-			11			43			-			43

Total interest bearing liabilities		(634	)		(132	)		(766	)		(1,579	)		29			(1,550	)

Net change in net interest income	$	(338	)	$	(882	)	$	(1,220	)	$	(251	)	$	(2,340	)	$	(2,591	)

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, 2011 and 2010. The tables show the dollar and percentage change from 2010 to 2011. Below each table is a discussion of significant changes and trends.

	Three Months Ended
	September 30,
(Dollars in thousands)	2011			2010			Change			%
Non-interest income
Customer service fees on deposit accounts	$	1,620		$	1,671		$	(51	)		-3.1	%
Gain on sale of mortgage loans		268			513			(245	)		-47.8	%
Gain on sale of investments		92			7			85			1214.3	%
Net impairment losses recognized in earnings		(64	)		(649	)		585			-90.1	%
Loss on sale and write downs of real estate acquired through foreclosure		(3,315	)		(374	)		(2,941	)		786.4	%
Brokerage commissions		124			109			15			13.8	%
Other income		348			703			(355	)		-50.5	%
	$	(927	)	$	1,980		$	(2,907	)		-146.8	%

	Nine Months Ended
	September 30,
(Dollars in thousands)	2011			2010			Change			%
Non-interest income
Customer service fees on deposit accounts	$	4,619		$	4,935		$	(316	)		-6.4	%
Gain on sale of mortgage loans		824			1,227			(403	)		-32.8	%
Gain on sale of investments		323			7			316			4514.3	%
Loss on sale of investments		(38	)		(23	)		(15	)		65.2	%
Net impairment losses recognized in earnings		(168	)		(832	)		664			-79.8	%
Loss on sale and write downs of real estate acquired
through foreclosure		(8,201	)		(838	)		(7,363	)		878.6	%
Brokerage commissions		339			309			30			9.7	%
Other income		1,203			1,514			(311	)		-20.5	%
	$	(1,099	)	$	6,299		$	(7,398	)		-117.4	%

Customer service fees on deposit accounts, our largest component of non-interest income, decreased for 2011 due to a decline in consumer overdraft activity. Contributing to the decline in consumer overdraft activity were the amended Regulation E guidelines, which took effect on August 15, 2010. The amended Reg E guidelines prohibit financial institutions from charging consumers fees for paying overdrafts on automated teller machine and one-time debit card transactions, unless a consumer affirmatively consents, or opts in, to the overdraft service for those types of transactions. We believe these guidelines will have a negative impact on our net income for 2011 and beyond. We are evaluating all of the fees we charge for our deposit products to determine if and when we will revise fees in an effort to partially mitigate the anticipated loss of overdraft related income.

We originate qualified VA, KHC, 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 2011 due to a decrease in the volume of loans refinanced, originated and sold due to the stabilizing interest rate environment.

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 2011 we recorded a gain on the sale of debt investment securities of $323,000 and a loss on the sale of debt investment securities of $38,000. During 2010 we recorded a loss on the sale of an equity investment security of $23,000 and the gain on the sale of another equity investment of $7,000. Gains on investment securities are infrequent and are not a consistent recurring core source of income.

We recognized other-than-temporary impairment charges of $168,000 for the expected credit loss during the 2011 period on three of our trust preferred securities, compared to $832,000 of impairment charges for 2010. Management believes this impairment was primarily attributable to the current economic environment which caused the financial conditions of some of the issuers to deteriorate.

Further reducing non-interest income for 2011 was an increase of $7.4 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.

The decrease in other income for the 2011 period was the result of a reduction in loan fee income due to a decline in loan activity.

	Three Months Ended
	September 30,
(Dollars in thousands)	2011		2010		Change			%
Non-interest expense
Employee compensation and benefits	$	4,060	$	4,176	$	(116	)		-2.8	%
Office occupancy expense and equipment		804		779		25			3.2	%
Marketing and advertising		101		225		(124	)		-55.1	%
Outside services and data processing		874		622		252			40.5	%
Bank franchise tax		342		566		(224	)		-39.6	%
FDIC insurance premiums		679		615		64			10.4	%
Amortization of core deposit intangible		64		77		(13	)		-16.9	%
Real estate acquired through foreclosure expense		476		302		174			57.6	%
Loan expense		1,358		129		1,229			952.7	%
Other expense		1,282		1,223		59			4.8	%
	$	10,040	$	8,714	$	1,326			15.2	%

	Nine Months Ended
	September 30,
(Dollars in thousands)	2011		2010		Change			%
Non-interest expense
Employee compensation and benefits	$	12,347	$	12,171	$	176			1.4	%
Office occupancy expense and equipment		2,447		2,351		96			4.1	%
Marketing and advertising		490		675		(185	)		-27.4	%
Outside services and data processing		2,727		2,020		707			35.0	%
Bank franchise tax		998		1,482		(484	)		-32.7	%
FDIC insurance premiums		2,555		1,969		586			29.8	%
Amortization of core deposit intangible		217		229		(12	)		-5.2	%
Real estate acquired through foreclosure expense		1,504		916		588			64.2	%
Loan expense		2,169		328		1,841			561.3	%
Other expense		3,908		3,481		427			12.3	%
	$	29,362	$	25,622	$	3,740			14.6	%

Outside services expense increased due to expenses incurred in connection with loan workout activities and the addition of loan workout specialists. Offsetting this increase was a decrease in marketing and advertising related expenses for the quarter and year to date due to cost cutting initiatives.

The FDIC adopted a requirement that all banks prepay three and a quarter years worth of FDIC assessments on December 31, 2009. The prepaid amount will be amortized over the prepayment period. Our prepayment was $7.5 million of which $2.6 million was reflected in our 2011 income statement. Because the Bank entered into the Consent Order and is designated a “troubled institution” it is in a higher risk category and now pays a higher assessment rate.

The increase in real estate acquired through foreclosure expense was primarily due to increases in expense relating to repair, maintenance, insurance, attorney fees and taxes due to a higher volume of properties in this portfolio at September 30, 2011.

Loan expense increased due to increases in loan portfolio management expenses such as the cost of obtaining new appraisals on real estate securing some of our commercial real estate loans. The increase in loan expense reflects our elevated level of non-performing loans.

Other expense increased primarily due to increases in interchange expense, examination and legal fees.

Income Taxes

The provision for income taxes includes federal and state income taxes and in 2011 reflects a full valuation allowance against all of our deferred tax assets that are not currently recoverable through carryback. The effective tax rates for the nine months ended September 30, 2011 and 2010 were 13% and 43%, respectively. Historically, the fluctuations in effective tax rates reflect the effect of the 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 various factors including our three year cumulative loss position and that we did not meet our forecast levels in 2010 and 2011. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at September 30, 2011 and December 31, 2010. Our 2011 tax benefit is entirely due to gains in other comprehensive income that are presented in current operations in accordance with applicable accounting standards. 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.

ANALYSIS OF FINANCIAL CONDITION

Total assets decreased $95.7 million to $1.2 billion at September 30, 2011 compared to December 31, 2010. The decrease was primarily due to a decline in gross loans, excluding loans held for sale, of $118.8 million and the decline in interest bearing deposits of $131.0 million. This decrease was mainly offset by building our investment portfolio to $332.4 million, an increase of $136.2 million since December 31, 2010. This shift in the balance sheet reflects a conscious effort by management to add on-balance sheet liquidity to better protect us against adverse changes to our current wholesale funding position.

Loans

Net loans decreased $111.2 million to $757.1 million at September 30, 2011 compared to $868.3 million at December 31, 2010. Our commercial real estate and commercial portfolios decreased $92.0 million to $510.5 million at September 30, 2011. Our residential mortgage loan, real estate construction, consumer and home equity and indirect consumer portfolios all decreased for the 2011 period. The decline in our commercial real estate and commercial loan portfolios is a result of pay-offs, charge-offs on large commercial real estate loans, and commercial loans being transferred to real estate acquired through foreclosure. Charge-offs made up $26.2 million or 23.6 % of this decrease.

	September 30,			December 31,
(Dollars in thousands)	2011			2010

Commercial	$	31,910		$	44,747
Commercial Real Estate:
Land Development		38,396			56,086
Building Lots		8,938			11,333
Other		431,227			490,345
Real estate construction		5,494			11,034
Residential mortgage		154,495			164,049
Consumer and home equity		71,363			77,822
Indirect consumer		24,146			29,588
Loans held for sale		7,367			6,388
		773,336			891,392
Less:
Net deferred loan origination fees		(257	)		(473	)
Allowance for loan losses		(16,018	)		(22,665	)
		(16,275	)		(23,138	)

Net Loans	$	757,061		$	868,254

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 Allowance for Loan Loss 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 loans based upon the risk classification and the estimated potential for loss. In addition, the Committee analyzes such factors as changes in lending policies and procedures; 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.

Further 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. Beginning the second half of 2008 and continuing into 2011, we substantially increased our provision for loan losses for our general and specific reserves as we identified adverse conditions. The foreseeable future will continue to be a challenging time as we manage the overall level of our credit quality. It is likely that provision for loan losses will remain elevated in the near term.

As discussed in Note 2 to the consolidated financial statements, we 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 a plan to reduce the level of non-performing assets through collection, disposition, charge-off or improvement in the credit quality of the loans, develop and implement a plan to reduce concentrations of credit in commercial real estate loans, implement revised credit risk management practices and credit administration policies and procedures and to 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)	2011		2010		2011			2010

Balance at beginning of period	$	17,708	$	20,953	$	22,665		$	17,719

Loans charged-off:
Residential mortgage		206		165		429			165
Consumer & home equity		140		141		362			463
Commercial & commercial real estate		7,524		6,970		25,414			8,552
Total charge-offs		7,870		7,276		26,205			9,180
Recoveries:
Residential mortgage		8		-		8			-
Consumer & home equity		36		39		157			136
Commercial & commercial real estate		12		48		287			63
Total recoveries		56		87		452			199

Net loans charged-off		7,814		7,189		25,753			8,981

Provision for loan losses		6,124		6,327		19,106			11,353

Balance at end of period	$	16,018	$	20,091	$	16,018		$	20,091

Allowance for loan losses to total loans (excluding loans held for sale)						2.09	%		2.18	%
Annualized net charge-offs to average loans outstanding						4.11	%		1.24	%
Allowance for loan losses to total non-performing loans						28	%		33	%

Provision for loan loss expense decreased by $203,000 to $6.1 million for the three months ended September 30, 2011, compared to the same period ended September 30, 2010. Provision for loan loss increased $7.8 million to $19.1 million for the nine months ended September 30, 2011, compared to the same nine month period in 2010. The increase was primarily related to residential housing development and building lot loans in Jefferson and Oldham Counties and our continued efforts to ensure the adequacy of the allowance by adding specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. We require appraisals and perform evaluations on impaired assets upon initial identification. Subsequently, 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 upon foreclosure. The higher provision was also due to our increasing the general reserve provisioning levels for commercial real estate loans due to the higher level of charge-offs, the general credit quality trend, and an increase in classified loans for the 2011 period.

The allowance for loan losses decreased $4.1 million to $16.0 million from September 30, 2010 to September 30, 2011. The decrease was due to net charge-offs of $25.8 million taken during the period which exceeded the provision for loan losses by $6.7 million. We charged off specific reserves of $10.2 million on our collateral dependent loans of which $8.7 million was previously reserved for at December 31, 2010, in addition to taking other write downs on loans to reflect updated appraisal information obtained as part of our on-going monitoring of the loan portfolio. This was due to appraisal values declining significantly on one to four family residential developments during 2011 above declines experienced during 2010. We believe these values are at or near liquidation value at September 30, 2011. We also believe this concentration has been fully identified and properly risk rated. The pass loans in this concentration have been separately evaluated for general allowance allocations. The decline in the specific reserves from charge-offs resulted in a decline in the allowance as a percent of total loans and the allowance as a percent of non-performing loans. The allowance for loan losses as a percent of total loans was 2.09% for September 30, 2011 compared to 2.18% at September 30, 2010. Specific reserves as allocated to substandard loans made up 27% of the total allowance for loan loss at September 30, 2011. Net charge-offs for the 2011 nine month period included $12.9 million in partial charge-offs compared to partial charge-offs of $2.0 million at December 31, 2011. Allowance for loan losses to total non-performing loans declined to 28% at September 30, 2011 from 33% at September 30, 2010. The decline in the coverage ratio was due to the charge-off of specific reserves for September 30, 2011 as well as the increase in restructured loans.

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 for the periods indicated:

	September 30,		June 30,		March 31,		December 31,		September 30,
(Dollars in thousands)	2011		2011		2011		2010		2010
Criticized Loans:
Total Criticized	$	17,893	$	26,972	$	35,338	$	28,309	$	29,285

Classified Loans:
Substandard	$	99,018	$	94,688	$	105,370	$	95,663	$	97,544
Doubtful		345		534		638		583		43
Loss		-		-		178		64		2,506
Total Classified	$	99,363	$	95,222	$	106,186	$	96,310	$	100,093

Total Criticized and Classified	$	117,256	$	122,194	$	141,524	$	124,619	$	129,378

Approximately $88.6 million or 89% of the total classified loans at September 30, 2011 were related to commercial real estate loans in our market area. Several of the non-performing loans that were added during the 2011 period were adequately collateralized and therefore did not require additional reserves. Classified consumer loans totaled $1.4 million, classified mortgage loans totaled $5.4 million and classified commercial loans totaled $4.0 million. The change in our level of allowance for loan losses is a result 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 active 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. Credit quality will continue to be a primary focus during 2011 and going forward.

Non-Performing Assets

Non-performing assets consist of certain restructured loans for which 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. 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 payments 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.

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.

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 the lower of the unpaid principal balance of the related loan or its fair value. 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 fair 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 increased $3.4 million to $29.2 million at September 30, 2011. We anticipate that our level of real estate acquired through foreclosure will remain at elevated levels for some period of time as foreclosures reflecting both weak economic conditions and soft commercial real estate values continue. All properties held in other real estate owned are listed for sale with various independent real estate agents.

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

	Nine Months Ended			Year Ended
	September 30,			December 31,
(Dollars in thousands)	2011			2010

Beginning balance	$	25,807		$	8,428
Additions		16,140			24,622
Sales		(4,845	)		(4,928	)
Writedowns		(7,922	)		(2,315	)
Ending balance	$	29,180		$	25,807

The following table provides information with respect to non-performing assets for the periods indicated.

	September 30,			December 31,
(Dollar in thousands)	2011			2010

Restructured on non-accrual status	$	23,302		$	-
Restructured on accrual status		5,494			3,906
Past due 90 days still on accrual		-			-
Loans on non-accrual status		28,155			42,169

Total non-performing loans		56,951			46,075
Real estate acquired through foreclosure		29,180			25,807
Other repossessed assets		36			40
Total non-performing assets	$	86,167		$	71,922

Interest income that would have been earned on non-performing loans	$	3,138		$	2,654
Interest income recognized on non-performing loans		940			277
Ratios: Non-performing loans to total loans
(excluding loans held for sale)		7.44	%		5.21	%
Non-performing assets to total assets		7.04	%		5.45	%

Non-performing loans increased $10.9 million to $57.0 million at September 30, 2011 compared to $46.1 million at December 31, 2010. The increase for the nine months ended September 30, 2011 was the result of an increase in restructured loans of $24.9 million and the addition of ten non-accrual relationships totaling $15.4 million. Offsetting this increase was a decrease in non-accrual loans due to write-downs of $22.4 million based upon updated appraisals and five non-accrual relationships totaling $6.3 million that were transferred to real estate acquired through foreclosure. Our exposure to commercial real estate in Jefferson and Oldham Counties was the primary cause of the increase in non-performing loans and non-performing assets for 2011, 2010 and 2009. Residential subdivision developments were our largest risk and concentration during these periods. At September 30, 2011, substantially all of the residential housing development loan portfolio concentration in these counties has been classified as impaired. The remaining credits in this concentration are smaller credits with strong guarantors. All non-performing loans are considered impaired.

Non-performing assets include restructured commercial, mortgage and consumer loans which increased $24.9 million at September 30, 2011 compared to December 31, 2010. The increase resulted from short term interest only periods granted for three loan relationships totaling $20.1 million and the restructuring of a residential housing development loan for $2.1 million. Two of the newly restructured credits are strip centers that experienced vacancies. One strip center lost a big box retailer and is currently in discussions with another larger retailer to fill the vacancy. The interest only period is to allow for the borrower to secure the new tenant. The second strip center has partially replaced a vacancy with a new tenant and was granted an interest only period to fill the remaining space. The loans were evaluated as impaired loans and appropriately allocated specific reserve allowances.

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. The borrowers are currently meeting the terms of the restructured loans. We anticipate that our level of restructured loans will continue to increase as we identify borrowers in financial difficulty and work with them to modify to more affordable terms.

Investment Securities

Interest on securities provides us our largest source of interest income after interest on loans, constituting 14.4% of the total interest income for the nine months ended September 30, 2011. 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 available-for-sale investment portfolio increased by $136.3 million due to the purchase of U.S. Government agency securities, government-sponsored mortgage-backed securities and obligations of states and political subdivisions.

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 U. S. Treasury and agency securities and our government sponsored mortgage-backed residential 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 have the ability and intent to hold 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, 2011.

We have evaluated the decline in the fair value of our trust preferred securities, which are directly related to the credit and liquidity crisis that the financial services industry has experienced in recent years. The trust preferred securities market is currently inactive, making the valuation of trust preferred securities very difficult. We value trust preferred securities using unobservable inputs through a discounted cash flow analysis as permitted under current accounting guidance and using the expected cash flows appropriately discounted using present value techniques. Refer to Note 9 – Fair Value for more information.

We recognized other-than-temporary impairment charges of $168,000 for the expected credit loss during the 2011 period and $2.1 million during the time we have held these securities on five of our trust preferred securities with an original cost basis of $3.0 million. All of our trust preferred securities are currently rated below investment grade. One of our trust preferred securities continues to pay interest as scheduled through September 30, 2011, and is expected to continue paying interest as scheduled. The other four trust preferred securities are paying either partial or full interest in kind instead of full cash interest. 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 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 .

Total deposits decreased $65.5 million compared to December 31, 2010. Retail and commercial deposits decreased $41.1 million. Public funds and Certificate of Deposits Account Registry Service (“CDARS”) certificates decreased $24.4 million. The decline in money market balances was partially due to a decline in the balance of one of our commercial customers who used $10.0 million in money market funds to pay down a loan. Brokered deposits were $90.3 million at September 30, 2011 and December 31, 2010. As a result of our Consent Order with bank regulatory agencies in January 2011, we are no longer allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval.

We continue to offer attractive certificate rates for various terms to allow us to retain deposit customers and reduce interest rate risk during the current rate environment, while protecting the margin. However, the Consent Order resulted in the Bank being categorized as a "troubled institution" by bank regulators. The "troubled institution" designation restricts the amount of interest the Bank may pay on 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 within .75% of the average rates computed by the FDIC. The Bank must apply annually to be granted this waiver, which it has done and was granted for 2011.

The following table breaks down our deposits.

	September 30,		December 31,
	2011		2010
	(In Thousands)

Non-interest bearing	$	77,892	$	73,566
NOW demand		144,224		129,887
Savings		86,316		109,349
Money market		138,471		157,135
Certificates of deposit		661,497		703,971
	$	1,108,400	$	1,173,908

We have public funds deposits from certain school boards, water districts and municipalities within our markets. These deposits are larger than individual retail depositors. We do not have a deposit relationship that is significant enough to cause a negative impact on our liquidity position. We have bid and won a three-year bid for our largest public funds depositor in Bullitt County and a smaller, but influential, public funds depositor in Hardin County during the third quarter of 2011.

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 of Cincinnati (FHLB) to compensate for reductions in deposits or deposit inflows at less than projected levels. At September 30, 2011 we had $27.8 million in advances outstanding from the FHLB. In January 2011, a $25 million convertible fixed rate advance with an interest rate of 5.05% matured and was paid in full. At September 30, 2011, we had sufficient collateral available to borrow, approximately, an additional $14.5 million in 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.

Subordinated Debentures

In 2008, an unconsolidated trust subsidiary of First Financial Service Corporation issued $8.0 million in trust preferred securities. The trust loaned the proceeds of the offering to us in exchange for junior subordinated deferrable interest debentures, which proceeds we used to finance the purchase of FSB Bancshares, Inc. The subordinated debentures, which mature on June 24, 2038, can be called at par in whole or in part on or after June 24, 2018. The subordinated debentures pay a fixed rate of 8% for thirty years. We have the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.

A different 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. The subordinated debentures, which mature March 22, 2037, can be called at par in whole or in part on or after March 15, 2017. We have the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.

Our trust subsidiaries loaned the proceeds of their offerings of trust preferred securities to us in exchange for junior subordinated deferrable interest debentures. We are not considered the primary beneficiary of these trusts (variable interest entity), therefore the trusts are not consolidated in our financial statements, but rather the subordinated debentures are shown as a liability. Our investment in the common stock of the trusts was $310,000.

On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes, together having an outstanding principal amount of $18 million, 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 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, 2011, these accrued but unpaid interest payments totaled $1.4 million.

LIQUIDITY

Liquidity risk arises from the possibility we may not be able to satisfy current or future financial commitments, or may become unduly reliant on alternative funding sources. The objective of liquidity risk management is to ensure that we can meet the cash flow requirements of depositors and borrowers, as well as our operating cash needs, at a reasonable cost, taking into account all on- and off-balance sheet funding demands. 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 Asset Liability Committee continually monitors our liquidity position.

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, 2011, we had sufficient collateral available to borrow, approximately, an additional $14.5 million in advances from the FHLB. We believe that we have adequate funding sources through unused borrowing capacity from our correspondent banks, unpledged investment securities, loan principal repayment and potential asset maturities and 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. The Bank’s Consent Order with the FDIC and KDFI 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 an agreement with the Federal Reserve to obtain regulatory approval before declaring any dividends. 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 2011, the Bank did not declare or pay any dividends to the Corporation. Cash held by the Corporation at September 30, 2011 was $125,000 compared to cash of $240,000 at December 31, 2010.

CAPITAL

Stockholders’ equity decreased $14.9 million for the period ended September 30, 2011 compared to December 31, 2010 primarily due to a net loss recorded during the period. Offsetting this decrease was a decrease in unrealized losses on securities available-for-sale. Our average stockholders’ equity to average assets ratio decreased to 5.39% for the nine months ended September 30, 2011 compared to 6.90% for the 2010 period.

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 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 after five years.

Under the terms of our CPP stock purchase agreement, we also issued the U.S. 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 the U.S. 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 the U.S. Treasury approved our application. The warrant has a term of 10 years and is potentially dilutive to earnings per share.

On October 29, 2010, we gave written notice to the U.S. Treasury that effective with the fourth quarter of 2010, we were suspending the payment of regular quarterly cash dividends on our Senior Preferred Shares. The dividends are cumulative and failure to pay dividends for six quarters would trigger the rights of the holder of our Senior Preferred Shares to appoint representatives to our Board of Directors. The dividends 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.

In addition to our agreement with the Federal Reserve that requires prior written consent to repurchase common shares, the terms of our Senior Preferred Shares do not allow us to repurchase shares of our common stock without the consent of the holder until the Senior Preferred Shares are redeemed. During the first nine months of 2011, we did not purchase any shares of our common stock.

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.

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

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, 2011.

	Capital Adequacy Ratios as of
	September 30, 2011
	Regulatory
Risk-Based Capital Ratios	Minimums			The Bank			The Corporation
Tier 1 capital		4.00	%		8.68	%		8.42	%
Total risk-based capital		8.00	%		9.94	%		9.68	%
Tier 1 leverage ratio		4.00	%		5.95	%		5.79	%

The Consent Order requires the Bank to achieve the minimum capital ratios presented below:

				Ratio Required
	Actual as of			by the Order
	9/30/2011			at 6/30/2011
Total capital to risk-weighted assets		9.94	%		12.00	%
Tier 1 capital to average total assets		5.95	%		9.00	%

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.

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, 2011 and December 31, 2010. Given a sustained 100 basis point decrease in rates, our base net interest income would decrease by an estimated 2.17% at September 30, 2011 compared to a decrease of .84% at December 31, 2010. Given a sustained 100 basis point increase in interest rates, our base net interest income would increase by an estimated 1.23% at September 30, 2011 compared to an increase of 2.69% at December 31, 2010.

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, 2011 and December 31, 2010 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, 2011 and December 31, 2010 annualized to a one year period.

	September 30, 2011
	Decrease in Rates								Increase in Rates
	200			100					100			200
(Dollars in thousands)	Basis Points			Basis Points			Base		Basis Points			Basis Points

Projected interest income
Loans	$	43,622		$	44,249		$	45,164	$	46,197		$	47,247
Investments		10,014			10,061			10,351		11,090			11,804
Total interest income		53,636			54,310			55,515		57,287			59,051

Projected interest expense
Deposits		14,792			14,815			15,197		16,502			17,095
Borrowed funds		2,366			2,366			2,366		2,366			2,366
Total interest expense		17,158			17,181			17,563		18,868			19,461

Net interest income	$	36,478		$	37,129		$	37,952	$	38,419		$	39,590
Change from base	$	(1,474	)	$	(823	)			$	467		$	1,638
% Change from base		(3.88	)%		(2.17	)%				1.23	%		4.32	%

	December 31, 2010
	Decrease in Rates								Increase in Rates
	200			100					100			200
(Dollars in thousands)	Basis Points			Basis Points			Base		Basis Points			Basis Points

Projected interest income
Loans	$	51,538		$	52,676		$	53,694	$	54,888		$	56,060
Investments		7,122			7,287			6,909		7,808			8,745
Total interest income		58,660			59,963			60,603		62,696			64,805

Projected interest expense
Deposits		17,668			17,764			18,068		19,048			19,278
Borrowed funds		2,491			2,491			2,490		2,525			2,554
Total interest expense		20,159			20,255			20,558		21,573			21,832

Net interest income	$	38,501		$	39,708		$	40,045	$	41,123		$	42,973
Change from base	$	(1,544	)	$	(337	)			$	1,078		$	2,928
% Change from base		(3.86	)%		(0.84	)%				2.69	%		7.31	%

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, 2011, an evaluation was performed under the supervision and with the participation of management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the restatement of the Company’s financial statements for the quarter and year ended December 31, 2010, the Company’s management and the Risk Management Committee of its Board of Directors determined that the Company’s internal controls over financial reporting of subsequent events related to the appraisal review process for other real estate owned and the timeliness of obtaining and reviewing real estate acquired through foreclosure was not effective. The Company’s management, overseen by the Risk Management Committee, implemented steps to improve the process for timely identification and improved communication of the events in the closing procedure that resulted in the material misstatement discovered in the closing procedure for the year and quarter ended December 31, 2010.

The enhanced procedures included:

Reviewing on a weekly basis any classified and/or collateral dependent loans as well as other real estate owned properties for new and updated appraisals, changes in market conditions and the status of the borrowers and/or guarantors by the executive loan committee; and

Establishing a tracking system to be shared with the finance department, loan officers and special assets officers showing property name, loan/asset number, and the date the appraisals were ordered, received and reviewed, and what, if any, change in valuation occurred.

During the second quarter, we took steps to resolve the material weakness by changing our procedures for handling appraisals, as discussed above. Notwithstanding the steps taken during the quarter, the identified material weakness will not be considered remediated until the new procedures have been in operation for a sufficient period of time to be tested and concluded by management to be operating effectively. There were no other changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2011 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

Although, from time to time, we are involved in various legal proceedings in the normal course of business, there are no material pending legal proceedings to which we are a party, or to which any of our property is subject.

Item 1A. Risk Factors

Except as set forth below, there have been no material changes from the risk factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2010 under Item 1A – Risk Factors. The risk factor entitled, “If we continue to incur significant losses, it may be difficult to continue in operation without additional capital” is being updated.

If we continue to incur significant losses, it may be difficult to continue in operation without additional capital.

We recorded a net loss to common shareholders of $22.2 million for the nine months ended September 30, 2011, a net loss to common shareholders of $10.5 million in 2010 and a net loss to common shareholders of $7.7 million in 2009, for a total loss of $40.4 million. The net loss for 2010 was due in part to a $4.8 million deferred tax valuation allowance. The net loss for 2009 was due in part to an $11.9 million non-cash pre-tax goodwill impairment charge.

Provisions for loan losses and investment impairments also contributed to our losses. During the first nine months of 2011, 2010 and 2009, we recorded total provisions for loan losses of $45.5 million and other than temporary losses on investments of $2.1 million. While our losses also included a charge off of goodwill of $11.9 million, and a charge to establish an allowance against the realization of our deferred tax asset of $4.8 million, these latter charges were largely influenced by the losses on loans and investments.

We could be required to make additional provisions for loan losses and impairments to investments if asset values continue to decline in the current economic climate. This in turn may require the Corporation to raise additional capital to fund the Bank's operations so that the Bank can sustain such losses and attain compliance with the minimum capital levels set forth in the Consent Order. See Part I, Item 1 – Business – Recent Developments , for a description of the Bank's capital requirements set forth in the Consent Order.

The risks identified in our risk factors are not the only risks we face. Additional risks and uncertainties not currently known to us or that we have deemed to be immaterial also may materially adversely affect our business, financial condition, and/or operating results.

In addition, you should carefully consider the following supplemental risk factors.

The Federal Reserve Bank’s (FRB’s) rule to repeal the prohibition against payment of interest on demand deposits may increase competition for such deposits and ultimately increase interest expense.

On July 21, 2011, the FRB’s rule to repeal of Regulation Q, which prohibited the payment of interest on demand deposits by institutions that are member banks of the Federal Reserve System, went into effect. The rule implements Section 627 of the Reform Act, which repeals Section 19(i) of the Federal Reserve Act in its entirety. As a result, banks and thrifts are now permitted to offer interest-bearing demand deposit accounts to commercial customers, which were previously forbidden under Regulation Q. The repeal of Regulation Q may cause increased competition from other financial institutions for these deposits. If the Bank decides to pay interest on demand accounts, it would expect interest expense to increase.

Downgrades of the current "AAA" credit rating assigned to U.S. Government could adversely affect the Bank.

On August 5, 2011, Standard & Poor's lowered the long-term sovereign credit rating assigned to the United States from "AAA" to "AA+" with a negative outlook, indicating a further rating downgrade is possible in the future. On August 2, 2011, Moody's Investors Service confirmed its "Aaa" rating for the United States with a negative outlook. Fitch Ratings has announced that it expects to complete a review of its "AAA" rating for the United States by the end of August and has not ruled out assigning the rating a negative outlook.

On August 5, 2011, the FDIC, Federal Reserve, OCC and National Credit Union Administration issued a joint press release stating that for risk-based capital purposes, the risk weights assigned to securities issued or guaranteed by the U.S. Government, its agencies and U.S. Government-sponsored entities will not change. However, a downgrade of the U.S. Government's sovereign credit rating below "AA" could cause a higher risk weight to be assigned to securities issued or guaranteed by the U.S Government or its agencies that we hold in our portfolio and increase our risk-based capital requirements. In addition, a ratings downgrade of securities issued or guaranteed by the U.S. Government or its agencies held in our portfolio could adversely affect the carrying value of such securities. At this time, we cannot assess the likelihood or severity of such a downgrade or the potential consequences it may have on either the capital position or investment portfolio of the Bank and Corporation.

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, 2011.

Item 3. Defaults Upon Senior Securities

Not Applicable

Item 4. [Removed and Reserved]

Item 5. Other Information

None

Item 6. Exhibits:

31.1		Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act

31.2		Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act

32		Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)

101		The following materials from the Quarterly Report of First Financial Service Corporation on Form 10-Q for the quarter ended September 30, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010, (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2011 and 2010, (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2011 and 2010, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2011, (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010, and (vi) Notes to the Unaudited Consolidated Financial Statements, tagged as blocks of text.

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, 2011	By:	/s/	B. Keith Johnson
		B. Keith Johnson
		Chief Executive Officer


Date: November 14, 2011	By:	/s/	Gregory S. Schreacke
		Gregory S. Schreacke
		President
		Chief Financial Officer &
		Principal Accounting Officer

INDEX TO EXHIBITS

Exhibit No.		Description

31.1		Certification of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act

31.2		Certification of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act

32		Certification of Chief Executive Officer and Chief 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 materials from the Quarterly Report of First Financial Service Corporation on Form 10-Q for the quarter ended September 30, 2011, formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets as of September 30, 2011 and December 31, 2010, (ii) Consolidated Statements of Income for the three and nine months ended September 30, 2011 and 2010, (iii) Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2011 and 2010, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the nine months ended September 30, 2011, (v) Consolidated Statements of Cash Flows for the nine months ended September 30, 2011 and 2010, and (vi) Notes to the Unaudited Consolidated Financial Statements, tagged as blocks of text.