**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

** **

**FORM 10-Q**

(Mark one)

**[X] QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

For the quarterly periodended **March 31, 2011**

or

**[ ] TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

For the transition periodfrom _______________ to _______________________

 

Commission File Numbers: 000-10972

 

First Farmers and MerchantsCorporation

(Exact name of registrant as specified in its charter)

 
| Tennessee                                                     | 62-1148660                          |
|---------------------------------------------------------------|-------------------------------------|
| (State or otherjurisdiction of incorporation or organization) | (I.R.S.Employer Identification No.) |
|                                                          |                                |
| 816 SouthGarden Street                                        |                                |
| Columbia, Tennessee                                           | 38402-1148                          |
| (Address of principalexecutive offices)                  | (Zip		Code)                         |

 

931-388-3145

(Registrant’s telephone number, including area code)

 

 

(Former name, former address and former fiscal year,if changed since last report)

              

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.               [X]Yes             [  ]No

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T during thepreceding 12 months (or for such shorter period that the registrant wasrequired to submit and post such files).  [  ]Yes  [  ] No

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company.  See definitions of “large accelerated filer,”“accelerated filer” and “smaller reporting company” in Rule 12b-2 of theExchange Act. 
| Large accelerated filer [    ]                                                       | Accelerated filer [ X ]                                            |
|-------------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------|
| Non-acceleratedfiler [    ] (Do not check if a smaller reporting company)       | Smaller reporting		company [    ]    |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theAct). [ ] Yes [X] No

 

As of May 5, 2011, the registrant had 5,395,460 sharesof common stock outstanding.

 

 

 

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** **

**PART I - FINANCIAL INFORMATIO**N

 

 

**Item 1. FinancialStatements.**

 

 

Thefollowing unaudited consolidated financial statements of the Registrant and itssubsidiaries are included in this Report:

 

Consolidatedbalance sheets – March 31, 2011 and December 31, 2010.

 

Consolidatedstatements of income - For the three months ended March 31, 2011 and March 31,2010.

 

Consolidatedstatements of cash flows - For the three months ended March 31, 2011 and March31, 2010.

 

Selectednotes to consolidated financial statements.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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| **FIRST FARMERS AND MERCHANTS CORPORATION AND  SUBSIDIARIES**                                                                     |
|-----------------------------------------------------------------------------------------------------------------------------------|
| **CONSOLIDATED BALANCE SHEETS**                                                                                                   |
|                                                                                                                              |   | **March 31,** |   | December 31, |
| ** **                                                                                                                        | ** ** | **2011** |   | 2010 |
|                                                                                                                              | (Dollars in Thousands, Except Per Share Data) | **(unaudited) ** |   | (1)  |
| **ASSETS**                                                                                                                        |   | ** ** |   |   |
|                                                                                                                              | Cash and due from banks | ** $** | **14,077 ** |   |  $ | 11,161  |
|                                                                                                                              | Interest-bearing due from banks | **12,247 ** |   | 4,238  |
|                                                                                                                              | Federal funds sold | **3,500 ** |   | 17,100  |
|                                                                                                                              |               Total cash and cash equivalents | **29,824 ** |   | 32,499  |
|                                                                                                                              | Securities | ** ** |   |   |
|                                                                                                                              |      Available-for-sale (amortized cost $267,273 | ** ** |   |   |
|                                                                                                                              |        and $237,496 respectively) | **265,905 ** |   | 236,180  |
|                                                                                                                              |      Held-to-maturity (fair market value $39,618 | ** ** |   |   |
|                                                                                                                              |        and $40,778, respectively) | **38,571 ** |   | 39,975  |
|                                                                                                                              |           Total Securities | **304,476 ** |   | 276,155  |
|                                                                                                                              | Loans, net of deferred fees | **551,357 ** |   | 559,179  |
|                                                                                                                              |      Allowance for loan and lease losses | **(7,694)** |   | (9,420) |
|                                                                                                                              |           Net loans | **543,663 ** |   | 549,759  |
|                                                                                                                              | Bank premises and equipment, | ** ** |   |   |
|                                                                                                                              |      at cost less allowance for depreciation | **22,941 ** |   | 22,842  |
|                                                                                                                              | Core deposit and other intangibles | **9,018 ** |   | 9,036  |
|                                                                                                                              | Other assets | **48,930 ** |   | 51,418  |
|                                                                                                                              |           TOTAL ASSETS | ** $** | **958,852 ** |   |  $ | 941,709  |
|                                                                                                                              |   | ** ** |   |   |
| **LIABILITIES**                                                                                                                   | Deposits | ** ** |   |   |
|                                                                                                                              |      Noninterest-bearing | ** $** | **135,705 ** |   |  $ | 123,541  |
|                                                                                                                              |      Interest-bearing (including certificates of  deposits | ** ** |   |   |
|                                                                                                                              |         over $100:  2011 - $106,074; 2010 -  $107,425) | **679,138 ** |   | 668,285  |
|                                                                                                                              |           Total deposits | **814,843 ** |   | 791,826  |
|                                                                                                                              | Federal funds purchased and securities | ** ** |   |   |
|                                                                                                                              |      sold under agreements to repurchase | **6,522 ** |   | 5,813  |
|                                                                                                                              | Short-term borrowings | **414 ** |   | 372  |
|                                                                                                                              | Accounts payable and accrued liabilities | **13,286 ** |   | 13,376  |
|                                                                                                                              | Federal Home Loan Bank Advances | **17,100 ** |   | 24,100  |
|                                                                                                                              | TOTAL LIABILITIES | **852,165 ** |   | 835,487  |
|                                                                                                                              |   | ** ** |   |   |
| **SHAREHOLDERS'**                                                                                                                 | Common stock - $10 par value per share, 8,000,000  shares | ** ** |   |   |
| **EQUITY**                                                                                                                        |         authorized; 5,395,460 and 5,430,000 shares  issued | ** ** |   |   |
|                                                                                                                              |         and outstanding as of  March 31, 2011 and | ** ** |   |   |
|                                                                                                                              |          December 31, 2010, respectively | **53,955 ** |   | 54,300  |
|                                                                                                                              | Retained earnings | **53,479 ** |   | 52,636  |
|                                                                                                                              | Accumulated other comprehensive income | **(842)** |   | (809) |
|                                                                                                                              |         TOTAL SHAREHOLDERS' EQUITY BEFORE  NONCONTROLLING INTEREST - PREFERRED STOCK OF SUBSIDIARY | **106,592 ** |   | 106,127  |
|                                                                                                                              | Noncontrolling interest - preferred stock of  subsidiary | **95 ** |   | 95  |
|                                                                                                                              | TOTAL SHAREHOLDERS' EQUITY | **106,687 ** |   | 106,222  |
|                                                                                                                              |         TOTAL LIABILITIES AND | ** ** |   |   |
|                                                                                                                              |            SHAREHOLDERS' EQUITY | ** $** | **958,852 ** |   |  $ | 941,709  |
| The accompanying notes are an integral part of  consolidated financial statements.

(1)Derived from audited financial statements. |   |   |   |

** **

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** **
| **FIRST FARMERS AND MERCHANTS CORPORATION AND  SUBSIDIARIES**                                                                                                                                                                                                                                                                                                                                                                                                   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **                                                                      CONSOLIDATED STATEMENTS OF INCOME** |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |   |   | Three months ended |
| *(Dollars in Thousands Except Per Share Data)*                                                                                                                                                                                                                                                                                                                                                                                                                  | March 31, |
| * *                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   | **2011** |   | **2010** |
| * *                                                                                                                                                                                                                                                                                                                                                                                                                                                        |   |   | ** ** |   |   |
| **INTEREST AND**                                                                                                                                                                                                                                                                                                                                                                                                                                                | Interest and fees on loans |   | ** $** | **7,537  ** |   |  $ | 7,874   |
| **    DIVIDEND INCOME**                                                                                                                                                                                                                                                                                                                                                                                                                          | Income on investment securities |   | ** ** |   |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |      Taxable interest |   | **925  ** |   | 1,184   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |      Exempt from federal income tax |   | **933  ** |   | 896   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |      Dividends |   | **48  ** |   | 47   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |   |   | **1,906  ** |   | 2,127   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | Other interest income |   | **18  ** |   | 18   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |           TOTAL INTEREST INCOME |   | **9,461  ** |   | 10,019   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |   |   | ** ** |   |   |
| **INTEREST EXPENSE**                                                                                                                                                                                                                                                                                                                                                                                                                                            | Interest on deposits |   | **1,165  ** |   | 1,653   |
| ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                      | Interest on other borrowings |   | **207  ** |   | 274   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |           TOTAL INTEREST EXPENSE |   | **1,372  ** |   | 1,927   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |                NET INTEREST INCOME |   | **8,089  ** |   | 8,092   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | PROVISION FOR POSSIBLE LOAN AND LEASE LOSSES |   | **725  ** |   | 1,086   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | NET INTEREST INCOME AFTER PROVISION FOR LOAN AND  LEASE LOSSES |   | **7,364  ** |   | 7,006   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |   |   | ** ** |   |   |
| **NONINTEREST**                                                                                                                                                                                                                                                                                                                                                                                                                                                 | Trust department income |   | **526  ** |   | 560   |
| **     INCOME**                                                                                                                                                                                                                                                                                                                                                                                                                             | Service fees on deposit accounts |   | **1,603  ** |   | 1,609   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | Other fees and commissions |   | **200  ** |   | 115   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | Other operating income |   | **33  ** |   | 51   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | Securities gains |   | **60  ** |   | 503   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |           TOTAL NONINTEREST INCOME |   | **2,422  ** |   | 2,838   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |   |   | ** ** |   |   |
| **NONINTEREST**                                                                                                                                                                                                                                                                                                                                                                                                                                                 | Salaries and employee benefits |   | **4,134  ** |   | 4,116   |
| **    EXPENSE**                                                                                                                                                                                                                                                                                                                                                                                                                                  | Net occupancy expense |   | **604  ** |   | 641   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | Furniture and equipment expense |   | **293  ** |   | 258   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | Other operating expenses |   | **2,885  ** |   | 3,705   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |           TOTAL NONINTEREST EXPENSES |   | **7,916  ** |   | 8,720   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | INCOME BEFORE PROVISION FOR INCOME TAXES |   | **1,870  ** |   | 1,124   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | PROVISION FOR INCOME TAXES |   | **325  ** |   | (68) |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | Net income before noncontrolling interest -  dividends on preferred stock of subsidiary |   | **1,545  ** |   | 1,192   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            | Noncontrolling interest - dividends on preferred  stock of subsidiary |   | **-  ** |   | -   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |       NET INCOME AVAILABLE FOR COMMON SHAREHOLDERS |   | ** $** | **1,545  ** |   |  $ | 1,192   |
| **BASIC EARNINGS**                                                                                                                                                                                                                                                                                                                                                                                                                                              |   |   | ** ** | ** ** |   |
| **PER SHARE**                                                                                                                                                                                                                                                                                                                                                                                                                                                   | Weighted Average Shares Outstanding |   | **5,427,650  ** | ** ** | 5,504,030   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |  Earnings per share |   | ** $** | **0.28  ** |   |  $ | 0.22   |
| The accompanying notes are an integral part of the  consolidated financial statements.                                                                                                                                                                                                                                                                                                                                                                          |   |   |   |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                            |   |   |   |   |   |

** **

 

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| **FIRST FARMERS AND  MERCHANTS CORPORATION AND SUBSIDIARIES**                                                                                    |
|--------------------------------------------------------------------------------------------------------------------------------------------------|
| **CONSOLIDATED STATEMENTS OF CASH  FLOWS                 ** |
| * *                                                                                                                                         | * * | **Three months ended March 31,** |
|                                                                                                                                             | *(Dollars in Thousands)* | **2011** | 2010 |
| **OPERATING**                                                                                                                                    | Net income available for common shareholders | ** $          1,545** |  $      1,192 |
| **ACTIVITIES**                                                                                                                                   |    Adjustments to reconcile net income to net cash  provided | ** ** |   |
|                                                                                                                                             |      by (used in) operating activities | ** ** |   |
|                                                                                                                                             |        Excess of provision for possible loan losses | ** ** |   |
|                                                                                                                                             |           over net charge-offs | **                725** |          1,086 |
|                                                                                                                                             |        Provision for depreciation and amortization of | ** ** |   |
|                                                                                                                                             |           premises and equipment | **                306** |             289 |
|                                                                                                                                             |        Deferred tax expense (benefit) | **                346** |             (56) |
|                                                                                                                                             |        Net securities gains | **                (60)** |           (502) |
|                                                                                                                                             |        (Gain) from disposition of other real estate | **                (25)** |             (49) |
|                                                                                                                                             |        Amortization of deposit base intangibles | **                  18** |               19 |
|                                                                                                                                             |        Amortization of investment security premiums, | ** ** |   |
|                                                                                                                                             |           net of accretion of discounts | **                366** |             393 |
|                                                                                                                                             |        Increase in cash surrender value of life  insurance contracts | **              (181)** |           (248) |
|                                                                                                                                             |        (Increase) decrease in | ** ** |   |
|                                                                                                                                             |           Other real estate owned | **                236** |           (549) |
|                                                                                                                                             |           Other assets | **             2,171** |           (971) |
|                                                                                                                                             |        Increase (decrease) in | ** ** |   |
|                                                                                                                                             |           Other liabilities | **              (127)** |           (313) |
|                                                                                                                                             |                Total adjustments | **             3,775** |           (901) |
|                                                                                                                                             |                Net cash provided by operating  activities | **             5,320** |             291 |
| **INVESTING**                                                                                                                                    | Proceeds from maturities, calls, and sales of | ** ** |   |
| **ACTIVITIES**                                                                                                                                   |       available-for-sale securities | **           39,391** |        51,592 |
|                                                                                                                                             | Proceeds from maturities and calls of  held-to-maturity securities | **             1,404** |          5,181 |
|                                                                                                                                             | Purchases of investment securities | ** ** |   |
|                                                                                                                                             |       Available-for-sale | **         (69,476)** |      (81,877) |
|                                                                                                                                             | Net increase in loans | **             5,371** |          2,366 |
|                                                                                                                                             | Proceeds from sale of foreclosed assets | **                     -** |             910 |
|                                                                                                                                             | Purchases of premises and equipment | **              (406)** |           (197) |
|                                                                                                                                             |                Net cash used in investing activities | **         (23,716)** |      (22,025) |
| **FINANCING**                                                                                                                                    | Net increase in noninterest-bearing | ** ** |   |
| **ACTIVITIES**                                                                                                                                   |       and interest-bearing deposits | **           23,017** |        38,769 |
|                                                                                                                                             | Net increase (decrease) in short term borrowings | **                751** |        (2,145) |
|                                                                                                                                             | Payments to FHLB borrowings | **           (7,000)** |        (7,000) |
|                                                                                                                                             | Repurchase of common stock | **           (1,047)** |           (768) |
|                                                                                                                                             | Cash dividends paid on common stock | **                     -** |        (2,038) |
|                                                                                                                                             |                Net cash provided by financing  activities | **           15,721** |        26,818 |
|                                                                                                                                             | (Decrease) increase in cash and cash equivalents | **           (2,676)** |          5,084 |
|                                                                                                                                             | Cash and cash equivalents at beginning of period | **           32,499** |        33,463 |
|                                                                                                                                             | Cash and cash equivalents at end of period | ** $        29,824** |  $    38,547 |
|      The accompanying notes are an integral part of  the consolidated financial statements.                                  |   |   |

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**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

 

**NOTE 1 – SUMMARY OFSIGNIFICANT ACCOUNTING POLICIES**

 

The interim unaudited consolidated financial statements ofFirst Farmers and Merchants Corporation (the “Corporation”) presented in thisreport have been prepared on a consistent basis and in accordance with theinstructions to Form 10-Q and do not include all of the information and notesrequired by generally accepted accounting principles for complete financialstatements.  Management has evaluated all significant events and transactionsthat occurred through May 5, 2011, for potential recognition or disclosure inthese consolidated financial statements.  In the opinion of management, alladjustments considered necessary for a fair presentation have been included. These adjustments were of a normal, recurring nature and consistent withgenerally accepted accounting principles.  For further information, refer tothe consolidated financial statements and notes included in the Corporation’sAnnual Report on Form 10-K for the year ended December 31, 2010.   

 

**NOTE 2 – STOCKREPURCHASE**

** **

**           **During the first quarter of 2011, the Corporationpurchased from third-party sellers, 25,000 shares of the Corporation’s commonstock pursuant to negotiated agreements at a price of $30.00 per share and9,540 shares in connection with the settlement of a dispute involving a Bankcustomer’s estate,  for an aggregate purchase price of $1.05 million.

 

**NOTE 3 – FAIR VALUE MEASUREMENT**

** **

The fair value of an asset or liability is the pricethat would be received to sell that asset or paid to transfer that liability inan orderly transaction occurring in the principal market (or most advantageousmarket in the absence of a principal market) for such asset or liability. Inestimating fair value, the Corporation utilizes valuation techniques that areconsistent with the market approach, the income approach and/or the costapproach. Such valuation techniques are consistently applied. Inputs tovaluation techniques include the assumptions that market participants would usein pricing an asset or liability. Financial Accounting Standards Board (“FASB”)Accounting Standards Codification (“ASC”) Topic 820, “Fair Value Measurementsand Disclosures,” establishes a fair value hierarchy for valuation inputs thatgives the highest priority to quoted prices in active markets for identicalassets or liabilities and the lowest priority to unobservable inputs. The fairvalue hierarchy is as follows:

 
    - Level 1 Inputs  - Unadjusted quoted prices     in active markets for identical assets or liabilities that the reporting     entity has the ability to access at the measurement date.

 
    - Level 2 Inputs  - Inputs other than quoted     prices included in Level 1 that are observable for the asset or liability,     either directly or indirectly. These might include quoted prices for     similar assets or liabilities in active markets, quoted prices for     identical or similar assets or liabilities in markets that are not active,     inputs other than quoted prices that are observable for the asset or     liability (such as interest rates, volatilities, prepayment speeds, credit     risks, etc.) or inputs that are derived principally from or corroborated     by market data by correlation or other means.

 
    - Level 3 Inputs  - Unobservable inputs for     determining the fair values of assets or liabilities that reflect an     entity’s own assumptions about the assumptions that market participants     would use in pricing the assets or liabilities.

 

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A description of the valuation methodologies used forinstruments measured at fair value as well as the general classification ofsuch instruments pursuant to the valuation hierarchy is set forth below. Thesevaluation methodologies were applied to all of the Corporation’s and the Bank’sfinancial assets and financial liabilities of the Corporation and the Bankcarried at fair value effective January 1, 2008.  In general, fair value isbased on quoted market prices, where available.  If such quoted market pricesare not available, fair value is based on internally developed models thatprimarily use, as inputs, observable market-based parameters. Valuationadjustments may be made to ensure that financial instruments are recorded atfair value. These adjustments may include amounts to reflect counterpartycredit quality and the Corporation’s creditworthiness among other things, aswell as unobservable parameters.  Any such valuation adjustments are appliedconsistently over time.  The Corporation’s valuation methodologies may producea fair value calculation that may not be indicative of net realizable value orreflective of future fair values.  While management believes the valuationmethodologies are appropriate and consistent with other market participants, theuse of different methodologies or assumptions to determine the fair value ofcertain financial instruments could result in a different estimate of fairvalue at the reporting date.  Furthermore, the reported fair value amounts havenot been comprehensively revalued since the presentation dates and, therefore,estimates of fair value after the balance sheet date may differ significantlyfrom the amounts presented herein.

 

*Financial assets and financial liabilities measured atfair value on a recurring basis include the following:*

* *

*Federal funds sold* – At December 31, 2010, all the Bank’s federal funds sold were settledovernight.  As a result, the fair value of the federal funds is their carryingamount and therefore this asset is classified as Level 1 of the valuationhierarchy.

* *

*Securities available-for-sale***–** Securities classified as available-for-sale arereported at fair value utilizing Level 2 inputs.  For these securities, theCorporation obtains fair value measurements from an independent pricing service. The fair value measurements consider observable data that may include dealerquotes, market spreads, cash flows, the U.S. Treasury yield curve, live tradinglevels, trade execution data, market consensus prepayment speeds, creditinformation and the bond’s terms and conditions, among other things.

* *

*Other assets* – Included in other assets arecertain assets carried at fair value, including the cash value of Bank-ownedlife insurance policies.  The carrying amount of these assets is based oninformation received from the insurance carriers indicating the financialperformance of the policies and the amount the Bank would receive should thepolicies be surrendered.  The Bank reflects these investments within Level 2 ofthe valuation hierarchy.

** **

*Securities sold under repurchaseagreements (“repurchase agreements”), federal funds purchased and otherborrowings* – AtDecember 31, 2010, all of the Bank’s repurchase agreements, federal fundspurchased and other borrowings (overnight borrowings from the Federal Home LoanBank) are settled on a short-term basis, usually daily.  As a result, the fairvalue of the instruments approximates their carrying amount and suchliabilities are classified as Level 2 within the valuation hierarchy.

 

*Loans*– The fair value of portfolio loansassumes sale of the notes to a third party financial investor.  Accordingly,this value is not necessarily the value to the Corporation if the notes wereheld to maturity.  The Corporation considered interest rate, credit and marketfactors in estimating the fair value of loans.  In the current whole loanmarket, financial investors are generally requiring a much higher rate ofreturn than the return inherent in loans if held to maturity given the lack ofmarket liquidity.  This divergence accounts for the majority of the differencein carrying amount over fair value.

 

            *Deposits*– Thefair value of fixed maturity certificates of deposit is estimated using adiscounted cash flow calculation based on current rates offered for deposits ofsimilar remaining maturities.

 

            *FHLB Borrowings*– Thefair value of Federal Home Loan Bank of Cincinnati (the “FHLB”) borrowings isestimated using discounted cash flow analysis based on rates currentlyavailable to the Corporation for borrowings with similar terms.

 

      *Other liabilities* – TheBank has certain liabilities carried at fair value.  These include futureobligations pursuant to a supplemental retirement plan and proceeds ofsplit-dollar life insurance policies.  For these obligations, the Bankdiscounts the anticipated future cash flows using current interest rates.  Theliabilities are classified as Level 3 within the valuation hierarchy.   The obligations with a carrying value of $5.5 millionwere increased by a specific valuation model totaling approximately $600,000 toa total reported fair value of $6.1 million based on a model utilizing Level 3valuation inputs.

** **

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The following table summarizesfinancial assets and liabilities measured at fair value on a recurring basis asof March 31, 2011, segregated by the level of the valuation inputs within thefair value hierarchy utilized to measure fair value:

 
| **Assets and liabilities measured at fair value on a  recurring basis as of March 31, 2011**    |                                                                                                                                                                                   |
|-------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                            | Level 1                                                                                                                                                                                | Level 2 | Level 3 | Total |
| Federal funds sold                                                                              |  $                    3,500                                                        |  $                   -   |  $                     -   |  $           3,500 |
| Available-for-sale securities                                                                   |                              -   |              265,905 |                         -   |           265,905 |
| Other assets                                                                                    |                              -   |                22,822 |                         -   |             22,822 |
| **    Total assets at fair value**                                               |  $                    3,500                                                        |  $          288,727 |  $                     -   |  $       292,227 |
| Securities sold under repurchase agreements                                                     |  $                          -              |  $              6,936 |  $                     -   |  $           6,936 |
| Other liabilities                                                                               |                              -   |                       -   |                    6,258 |               6,258 |
| **    Total liabilities at fair value**                                          |  $                          -              |  $              6,936 |  $                6,258 |  $         13,194 |
|                                                                                            |                                                                                                                                                                                   |   |   |   |
| **Assets and liabilities measured at fair value on a  recurring basis as of December 31, 2010** |                                                                                                                                                                                   |
|                                                                                            | Level 1                                                                                                                                                                                | Level 2 | Level 3 | Total |
| Federal funds sold                                                                              |  $                  17,100                                                                   |  $                   -   |  $                     -   |  $         17,100 |
| Available-for-sale securities                                                                   |                              -   |              236,180 |                         -   |           236,180 |
| Other assets                                                                                    |                              -   |                22,641 |                         -   |             22,641 |
| **    Total assets at fair value**                                               |  $                  17,100                                                                   |  $          258,821 |  $                     -   |  $       275,921 |
| Securities sold under repurchase agreements                                                     |  $                          -              |  $              5,813 |  $                     -   |  $           5,813 |
| Other liabilities                                                                               |                              -   |                       -   |                    6,104 |               6,104 |
| **    Total liabilities at fair value**                                          |  $                          -              |  $              5,813 |  $                6,104 |  $         11,917 |

 

Certain financial assets and liabilities are measuredat fair value on a nonrecurring basis. These instruments are not measured atfair value on an ongoing basis but are subject to fair value adjustments incertain circumstances (for example, when there is evidence of impairment). Theonly financial asset or liability measured at fair value on a non-recurring basisfor first quarter 2011 was impaired loans.

 

*Impaired Loans*– Certain impaired loans are reported at the fair value of theunderlying collateral if repayment is expected solely from the collateral. Collateral values are estimated using Level 2 inputs based on observable marketdata or Level 3 inputs based on customized discounting criteria.  In the firstquarter 2011, certain impaired loans were re-measured and reported at fairvalue through a specific valuation allowance allocation of the allowance for loanand lease losses based on the fair value of the underlying collateral. Impaired loans with a carrying value of $22.8 million were reduced by specificvaluation allowance allocations totaling $1.0 million to a total reported fairvalue of $21.8 million based on collateral valuations utilizing Level 3valuation inputs.

 

*Non-Financial Assets and Non-Financial Liabilities*– Application ofASC Topic 820 to non-financial assets and non-financial liabilities becameeffective January 1, 2009.  The Corporation has no non-financial assets ornon-financial liabilities measured at fair value on a recurring basis. Certain  non-financial assets and non-financial liabilities measured at fairvalue on a non-recurring basis include foreclosed assets (upon initial recognitionor subsequent impairment), non-financial assets and non-financial liabilitiesmeasured at fair value in the second step of goodwill impairment test, andintangible assets and other non-financial long-lived assets measured at fairvalue for impairment assessment.  

 

During the first quarter 2011, certain foreclosedassets, upon initial recognition, were remeasured and reported at fair valuethrough a charge-off to the allowance for loan and lease losses based upon thefair value of the foreclosed asset.  The fair value of a foreclosed asset, uponinitial recognition, is estimated using Level 2 inputs based on observablemarket 

data or Level 3 inputs based on customized discounting criteria. Foreclosed assets measured at fair value totaled $7.7 million (utilizing Level2 valuation inputs) at March 31, 2011.  

 

ASC Topic 825 requires disclosure of the fair value offinancial assets and liabilities, including those financial assets andliabilities that are not measured and reported at fair value on a recurringbasis or non-recurring basis. The methodologies for estimating the fair valueof financial assets and liabilities that are measured at fair value on arecurring or non-recurring basis are discussed below.

 

 

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            Estimated fair values have been determined by the Bankusing the best available data.  Many of the Bank's financial instruments,however, lack an available trading market as characterized by a willing buyerand willing seller engaging in an unforced, unforeclosed transaction. Therefore, significant estimations and present value calculations were 

used by the Bank for the purposes of this disclosure.  Changes inassumptions or the estimation methodologies used could have a material effecton the estimated fair values included in this note.

 

                *Financialassets* – * *Cash andcash equivalents are considered to be carried at their fair value and have notbeen valued differently from historical cost accounting.  Both securitiesavailable-for-sale and held-to-maturity are 

valued by an independent pricing service as discussed in Note 2.  Apresent value discounted cash flow methodology was used to value the net loanportfolio.  The discount rate used in these calculations was the current rateat which new loans in the same classification for regulatory reporting purposeswould be made.  This rate was adjusted for credit loss and assumed prepaymentrisk.  For loans with floating interest rates, it is assumed that estimatedfair values generally approximate the recorded book balances.

   

*            Financial liabilities *– Deposits withstated maturities have been valued using a present value discounted cash flowwith a discount rate approximating the current market for similar liabilities. Financial instrument liabilities with no stated maturities have an estimatedfair value equal to both the amount payable on demand and the recorded bookbalance.  For deposits with floating interest rates, it is assumed thatestimated fair values generally approximate the recorded book balances.  Thecarrying amount of other short-term borrowings is considered to approximatefair value.

 

            Fair values for off-balance sheet, credit-related financialinstruments are based on fees currently charged to enter into similaragreements, taking into account the remaining terms of the agreements and thecounterparties’ credit standing.        

   

            At March 31, 2011, the Bank had outstanding standby lettersof credit and commitments to extend credit.  These off-balance sheet financialinstruments are generally exercisable at the market rate prevailing at the datethe underlying transaction will be completed and subject to customer’s creditquality.   

 

Theestimated fair values of financial instruments were as follows (dollars inthousands):

 
|                                                                                                | **March 31, 2011** | December 31, 2010 |
|-----------------------------------------------------------------------------------------------------|--------------------|-------------------|
|                                                                                                | **Carrying**       | **Fair**          | Carrying | Fair |
|                                                                                                | **Amount**         | **Value**         | Amount | Value |
| Financial assets                                                                                    | ** **         | ** **        |   |   |
|       Cash and due from banks                                              | ** $**        | **14,077 **  | ** $** | **14,077 ** |  $ | 11,161  |  $ | 11,161  |
|       Interest-bearing deposits in banks                                   | **12,247 **   | **12,247 **  | 4,238  | 4,238  |
|       Federal funds sold                                                   | **3,500 **    | **3,500 **   | 17,100  | 17,100  |
|       Securities available-for-sale                                        | **265,905 **  | **265,905 ** | 236,180  | 236,180  |
|       Securities held-to-maturity                                          | **38,571 **   | **39,618 **  | 39,975  | 40,778  |
|       Loans, net                                                           | **543,663 **  | **556,008 ** | 549,759  | 563,270  |
|       Accrued interest receivable                                          | **4,555 **    | **4,555 **   | 4,044  | 4,044  |
| Financial liabilities                                                                               | ** **         | ** **        |   |   |
|       Deposits                                                             | **814,843 **  | **783,232 ** | 791,826  | 793,270  |
|       Federal funds purchased and                                          | ** **         | ** **        |   |   |
|             securities sold under agreements | ** **         | ** **        |   |   |
|             to repurchase                    | **6,522 **    | **6,522 **   | 5,813  | 5,813  |
|       Other short term liabilities                                         | **414 **      | **414 **     | 372  | 372  |
|       FHLB borrowings                                                      | **17,100 **   | **17,773 **  | 24,100  | 24,901  |
|       Accrued interest payable                                             | **953 **      | **953 **     | 1,078  | 1,078  |
| Off-balance sheet credit related instruments:                                                       | ** **         | ** **        |   |   |
|       Commitments to extend credit                                         | ** **         | **94 **      |   | 95  |
|                                                                                                | ** **         | **- **       |   |  - |

 

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Under ASC Topic 825, entities may choose to measureeligible items at fair value at specified election dates.  Unrealized gains andlosses on items for which the fair value measurement option has been electedare reported in earnings at each subsequent reporting date. The fair valueoption (i) may be applied instrument by instrument, with certain exceptions;therefore, the Corporation may record identical financial assets andliabilities at fair value or by another measurement basis permitted undergenerally accepted accounting principles; (ii) is irrevocable (unless a newelection date occurs) and (iii) is applied only to entire instruments and notto portions of instruments.  During the reported periods, the Bank had nofinancial instruments measured at fair value under the fair value measurementoption. 

** **

**NOTE 4 – FEDERAL HOME LOAN BANK CREDIT LINE**

** **

The Bank has a Blanket Agreement for Advances and Security Agreement (the“Blanket Agreement”) with the FHLB.  Advances made to the Bank under theBlanket Agreement are collateralized by FHLB stock and unidentified qualifyingresidential mortgage loans totaling 150% of the outstanding amount borrowed.  The Bank made an annual principal payment of $7.0million to the FHLB under the Blanket Agreement on each of March 31, 2009,March 31, 2010 and March 31, 2011, with an additional payment of $3.1 millionon September 15, 2010.

 

Scheduled principal maturities of borrowings under thiscredit line as of March 31, 2011, were as follows (dollars in thousands):

| 2012  |   | $      7,000 |
|-------|--------|---------------------------------------|
| 2013  |   |       10,100 |
| Total |   |  $   17,100            |

 

Stock held in the FHLB totaling $3.0 million atMarch 31, 2011 is carried at cost.  The stock is restricted and can only besold to the FHLB at par.

 

The Bank also has a Cash Management Advance Line of Credit Agreement (the“CMA”) dated June 21, 2010, with the FHLB.  The CMA is a component of theBlanket Agreement.  The purpose of the CMA is to assist with short-termliquidity management.  Under the terms of the CMA, the Bank may borrow amaximum of $40.0 million, selecting a variable rate of interest for up to 90days or a fixed rate for a maximum of 30 days.  There were no borrowingsoutstanding under the CMA as of March 31, 2011.

 

**NOTE 5 – SECURITIES**

 

Securitieswith an amortized cost of $186.8 million and a fair value of $185.4 million at March31, 2011 were pledged to secure deposits and for other purposes as required orpermitted by law.  The fair value is established by an independent pricingservice as of the approximate dates indicated.  The differences between theamortized cost and fair value reflect current interest rates and represent thepotential gain if the portfolio had been liquidated on that date.  Securitygains are realized only in the event of dispositions prior to maturity.  

 

            Theamortized cost and estimated fair value of securities at March 31, 2011 were asfollows (dollars in thousands):
|                                                 | Amortized        | Gross Unrealized  | Fair          |
|------------------------------------------------------|------------------|-------------------|---------------|
| ** **                                           | Cost             | Gains             | Losses        | Value |
| Available-for-sale securities                        |             |              |          |   |
|     U.S. Government agencies          | ** $**      | **121,465 ** | ** $**   | **55 ** | ** $** | **2,162 ** | ** $** | **119,358 ** |
|     Mortgage backed securities        | **63,294 ** | **109 **     | **620 ** | **62,783 ** |
|     States and political subdivisions | **59,042 ** | **1,073 **   | **307 ** | **59,808 ** |
|     Other securities                  | **23,472 ** | **553 **     | **69 **  | **23,956 ** |
|                                                 | ** $**      | **267,273 ** | ** $**   | **1,790 ** | ** $** | **3,158 ** | ** $** | **265,905 ** |
| Held-to-maturity securities                          | ** **       | ** **        | ** **    | ** ** |
|     States and political subdivisions | ** $**      | **38,571 **  | ** $**   | **1,056 ** | ** $** | **9 ** | ** $** | **39,618 ** |
|                                                 | ** $**      | **38,571 **  | ** $**   | **1,056 ** | ** $** | **9 ** | ** $** | **39,618 ** |
|                                                      |                  |                   |               |  |  |  |  |  |  |  |  |

 

            At March31, 2011, the Bank did not hold investment securities of any single issuer, other thanobligations of U.S. government agencies, whose aggregate book value exceeded10% of shareholders’ equity.

 

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            Proceeds from the maturity, call or sale ofavailable-for-sale securities were $39.4 million during the three months endedMarch 31, 2011.  Proceeds from the maturity or call of held-to-maturitysecurities were $1.4 million during the three months ended March 31, 2011.

 

            If the fair values of any securities at March 31, 2011did not equal or exceed the cost of those securities, then the current fairvalue was considered temporarily impaired.  Management evaluatessecurities for other-than-temporary impairment periodically, or more frequentlywhen circumstances require an evaluation.  An impairment judgment is based on(i) the amount of time and loss, (ii) the financial condition of the issuer and(iii) management’s intent and ability to hold the investment long enough forany anticipated recovery in value.  

 

Managementhas the ability and intent to hold the securities classified asheld-to-maturity until they mature.  Furthermore, as of March 31, 2011,management also had the ability to hold the securities classified as available-for-salefor a period of time sufficient for a recovery of cost.  The unrealized lossesare largely a result of market fluctuations and variations in pricingappraisals.  Management does not believe any of the securities are impairedbecause of reasons of credit quality.  Accordingly, as of March 31, 2011, managementbelieves the impairments detailed in the table below are temporary and noimpairment loss has been realized in the Corporation’s consolidated incomestatement.

 

The following table presents the Bank’s investments with unrealized lossesat March 31, 2011 according to the term of the unrealized loss:

 
| **March 31, 2011**                                       | **Less than 12 months** | **12 months or Greater** | **Total**   |
|----------------------------------------------------------|-------------------------|--------------------------|-------------|
| ** **                                               | **Fair**                | **Unrealized**           | **Fair**    | ** ** | **Unrealized** | **Fair** | **Unrealized** |
| **Type of Security**                                     | **Value**               | **Losses**               | **Value**   | ** ** | **Losses** | **Value** | **Losses** |
| **     US Government agencies**      | ** $**             | **111,387 **        | ** $** | **2,162 ** | ** ** | ** ** | ** ** | **111,387 ** | **2,162 ** |
| **    Mortgage backed securities**        | **44,024 **        | **620 **            | ** **  | ** ** | ** ** | **44,024 ** | **620 ** |
| **    States and political subdivisions** | **11,396 **        | **307 **            | ** **  | ** ** | ** ** | **11,396 ** | **307 ** |
| **    Other securities**                  | **20,338 **        | **69 **             | ** **  | ** ** | ** ** | **20,338 ** | **69 ** |
| ** **                                               | ** $**             | **187,145 **        | ** $** | **3,158 ** | ** $** | **- ** | ** ** | ** $** | **- ** | ** $** | **187,145 ** | ** $** | **3,158 ** |
|                                                          |                         |                          |             |  |  |  |  |  |  |  |  |  |  |

 

 

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**           **The table below shows the amortizedcost and fair value of investment securities at March 31, 2011 by contractualor legal maturity.  Expected maturities may differ from contractual maturitiesbecause issuers may have the right to call or prepay obligations. Mortgage-backed securities and equity securities are shown separately becausethey are not due at a single maturity date.
|                                         | Amortized        | Fair             | Yield       |
|----------------------------------------------|------------------|------------------|-------------|
| (Dollars in Thousands)                       | Cost             | Value            | (Unaudited) |
| **Available-for-sale securities**            |             |             |        |
| U.S. Government agencies                     |             | ** **       |        |
|    Within one year                 |  $          | 5,014       | ** $** | **5,017 ** | 0.5 % |
|    After one but within five years | 50,754      | **50,216 ** | 1.6 %  |
|    After five but within ten years | 65,697      | **64,124 ** | 2.2 %  |
| Mortgage backed securities                   |             | ** **       |        |
|    Within one year                 | 49          | **49 **     | 4.7 %  |
|    After one but within five years | 53,130      | **52,710 ** | 1.3 %  |
|    After five but within ten years | 10,115      | **10,024 ** | 2.2 %  |
| States and political subdivisions            |             | ** **       |        |
|    After one but within five years | 6,809       | **7,027 **  | 2.6 %  |
|    After five but within ten years | 9,162       | **9,338 **  | 3.4 %  |
|    After ten years                 | 43,071      | **43,444 ** | 3.8 %  |
| Other securities                             |             |             |        |
|    Within one year                 | 1,907       | **1,954 **  | 3.8 %  |
|    After one but within five years | 15,371      | **15,810 ** | 3.1 %  |
|    After five but within ten years | 2,297       | **2,295 **  | 3.3 %  |
|    After ten years                 | 3,897       | **3,897 **  | 1.2 %  |
|                                         |  $          | 267,273     | ** $** | **265,905 ** |   |
| **Held-to-maturity securities**              |             |             |        |
| States and political subdivisions            | ** **       |             |        |
|    Within one year                 | ** $**      | **2,681 **  |  $     | 2,707  | 4.1 % |
|    After one but within five years | **9,157 **  | 9,423       | 3.8 %  |
|    After five but within ten years | **10,268 ** | 10,677      | 4.5 %  |
|    After ten years                 | **16,465 ** | 16,811      | 4.1 %  |
|                                         | ** $**      | **38,571 ** |  $     | 39,618  |   |
|                                              |                  |                  |             |  |  |  |  |

** **

**NOTE6 – LOANS**

 

            Thefollowing table presents the Bank’s loans by category as of March 31, 2011 andDecember 31, 2010 (dollars in thousands): 
|                                                 | **March 31,		2011**                                                                                  | **Percentage of		Total** | ** ** | December 31,		2010 | Percentage of		Total |
|------------------------------------------------------|------------------------------------------------------------------------------------------------------|--------------------------|------------|--------------------|----------------------|
|                                                 |                                                                                                 |                     |       |               |                 |
| Commercial, financial and agricultural               | ** $         68,193**                                   | **12.4%**                | ** ** |  $            | 67,156          | 12.0% |
| Tax exempt municipal loans                           | **            25,395**                        | **4.6%**                 | ** ** | 28,163        | 5.0%                 |
| Real estate                                          | ** **                                                                                           | ** **               | ** ** |               |                 |
|       Construction          | **            38,757**                        | **7.0%**                 | ** ** | 37,374        | 6.7%                 |
|       Commercial mortgages  | **          155,055**                                   | **28.0%**                | ** ** | 156,704       | 28.0%                |
|       Residential mortgages | **          219,786**                                   | **39.9%**                | ** ** | 221,749       | 39.7%                |
|       Other                 | **            29,759**                        | **5.4%**                 | ** ** | 31,129        | 5.6%                 |
| Retail loans                                         | **            14,889**                        | **2.7%**                 | ** ** | 17,394        | 3.0%                 |
|    Net unamortized loan origination fees   | **                (477)** | ** **               | ** ** | (490)              |                 |
| Total loans                                          | ** $       551,357**                                              | **100.0%**               | ** ** |  $            | 559,179         | 100.0% |

 

 

*LoanOrigination/Risk Management.*The Bankhas certain lending policies and procedures in place that are designed tomaximize loan income within an acceptable level of risk. Management reviews andapproves these policies and procedures on a regular basis. A reporting systemsupplements the review process by providing management with frequent reportsrelated to loan production, loan quality, concentrations of credit, loandelinquencies and non-performing and potential problem loans. Diversification in the loan portfolio is ameans of managing risk associated with fluctuations in economic conditions.

 

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Commercial and industrial loans are underwritten afterevaluating and understanding the borrower’s ability to operate profitably andprudently expand its business. Underwriting standards are designed to promoterelationship banking rather than transactional banking. Once it is determinedthat the borrower’s management possesses sound ethics and solid businessacumen, the Corporation’s management examines current and projected cash flowsto determine the ability of the borrower to repay their obligations as agreed.Commercial and industrial loans are primarily made based on the identified cashflows of the borrower and secondarily on the underlying collateral provided bythe borrower. The cash flows of borrowers, however, may not be as expected andthe collateral securing these loans may fluctuate in value. Most commercial andindustrial loans are secured by the assets being financed or other businessassets such as accounts receivable or inventory and may incorporate a personalguarantee; however, some short-term loans may be made on an unsecured basis. Inthe case of loans secured by accounts receivable, the availability of funds forthe repayment of these loans may be substantially dependent on the ability ofthe borrower to collect amounts due from its customers. 

 

Commercial real estate loans are subject tounderwriting standards and processes similar to commercial and industrialloans, in addition to those of real estate loans. These loans are viewedprimarily as loans secured by real estate. Commercial real estate lendingtypically involves higher loan principal amounts and the repayment of theseloans is generally largely dependent on the successful operation of theproperty securing the loan or the business conducted on the property securingthe loan. Commercial real estate loans may be more adversely affected byconditions in the real estate markets or in the general economy. Managementmonitors and evaluates commercial real estate loans based on collateral,geography and risk grade criteria. As a general rule, the Bank avoids financingsingle-purpose projects unless other underwriting factors are present to helpmitigate risk. The Bank also utilizes third-party experts to provide insightand guidance about economic conditions and trends affecting market areas itserves. In addition, management tracks the level of owner-occupied commercialreal estate loans versus non-owner occupied loans. At March 31, 2011,approximately half of the outstanding principal balance of the Bank’scommercial real estate loans were secured by owner-occupied properties.  

 

With respect to loans to developers and builders thatare secured by non-owner occupied properties that the Bank may originate fromtime to time, the Bank generally requires the borrower to have had an existingrelationship with the Bank and have a proven record of success. Constructionloans are underwritten utilizing feasibility studies, independent appraisalreviews, sensitivity analysis of absorption and lease rates and financialanalysis of the developers and property owners. Construction loans aregenerally based upon estimates of costs and value associated with the completeproject. These estimates may be inaccurate. Construction loans often involvethe disbursement of substantial funds with repayment substantially dependent onthe success of the ultimate project. Sources of repayment for these types ofloans may be pre-committed permanent loans from approved long-term lenders,sales of developed property or an interim loan commitment from the Bank untilpermanent financing is obtained. These loans are closely monitored by on-siteinspections and are considered to have higher risks than other real estateloans due to their ultimate repayment being sensitive to interest rate changes,governmental regulation of real property, general economic conditions and theavailability of long-term financing.

 

The Bank originates consumer loans utilizing a computer-basedcredit scoring analysis to supplement the underwriting process. To monitor andmanage consumer loan risk, policies and procedures are developed and modified,as needed, jointly by line and staff personnel. This activity, coupled withrelatively small loan amounts that are spread across many individual borrowers,minimizes risk. Additionally, trend and outlook reports are reviewed bymanagement on a regular basis. Underwriting standards for home equity loans areheavily influenced by statutory requirements, which include, but are notlimited to, a maximum loan-to-value percentage of 80%, collection remedies, thenumber of such loans a borrower can have at one time and documentationrequirements.

 

The Bank contracts with a third party vendor toperform loan reviews.  The Bank reviews and validates the credit risk programon an annual basis. Results of these reviews are presented to management. Theloan review process complements and reinforces the risk identification andassessment decisions made by lenders and credit personnel, as well as the Banks’spolicies and procedures. 

 

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The goal ofthe Bank is to diversify loans to avoid a concentration of credit in a specificindustry, person, entity, product, service, or any area vulnerable to a tax lawchange or an economic event. A concentration of credit occurs when obligations,direct or indirect, of the same or affiliated interests represent 15 percent ormore of the Bank's capital structure. The Board of Directors recognizes thatthe Bank's geographic trade area imposes some limitations regarding loandiversification if the bank is to perform the function for which it has beenchartered. Specifically, lending to qualified borrowers within the Bank's tradearea will naturally cause concentrations of real estate loans in the primarycommunities served by the Bank and loans to employees of major employers in thearea. 

 

The following table providesdetails regarding the aging of the Bank’s loan and lease portfolio as of March31, 2011 (dollars in thousands):

 
|                                         | 30 - 89       | Greater Than 90 |            |             |          |
|----------------------------------------------|---------------|-----------------|-----------------|------------------|---------------|
|                                         | Days Past Due | Days Past Due   | Total Past Dues | Current          | Total Loans   |
| **Retail**                                   |          |            |            |             |          |
|   Consumer loans                        |  $       | 100        |  $         | 104         |  $       | 204  |  $ | 13,176  |  $ | 13,380  |
|   Residential loans - first lien        | 936      | 1,655      | 2,591      | 146,530     | 149,121  |
|   Residential loans - junior lien       | -        | 132        | 132        | 949         | 1,081    |
|   HELOC's                               | 399      | 789        | 1,188      | 57,136      | 58,324   |
|   Other retail                          | 1,115    | 348        | 1,463      | 26,510      | 27,973   |
| **Retail Totals**                            | ** $**   | **2,550 ** | ** $**     | **3,028 **  | ** $**   | **5,578 ** | ** $** | **244,301 ** | ** $** | **249,879 ** |
| **Commercial**                               |          |            |            |             |          |
|   Commercial & industrial           |  $       | 141        |  $         | 1,478       |  $       | 1,619  |  $ | 58,761  |  $ | 60,380  |
|   Non-farm, non-residential real estate | 344      | 8,625      | 8,969      | 143,521     | 152,490  |
|   Construction & development        | -        | -          | -          | 34,428      | 34,428   |
|   Other commercial                      | 212      | 751        | 963        | 53,217      | 54,180   |
| **Commercial Totals**                        | ** $**   | **697 **   | ** $**     | **10,854 ** | ** $**   | **11,551 ** | ** $** | **289,927 ** | ** $** | **301,478 ** |
|                                         |          |            |            |             |          |
| **PORTFOLIO TOTALS**                         | ** $**   | **3,247 ** | ** $**     | **13,882 ** | ** $**   | **17,129 ** | ** $** | **534,228 ** | ** $** | **551,357 ** |
|                                              |               |                 |                 |                  |               |  |  |  |  |  |  |  |  |  |  |

 

            

The following table shows loans as of March 31, 2011related to each balance in the allowance for possible loan and lease losses byportfolio segment and disaggregated on the basis of the Bank’s impairmentmethodology (dollars in thousands):
| ** **                                  | **Commercial** | **Residential		real estate**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               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retail** | **Other**   | **Totals** |
|---------------------------------------------|----------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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| Loans individually evaluated for impairment | $              | 21,692                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  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     | 1,152  |  $    | -   |  $ | -   |  $ | 22,844 |
| Loans collectively evaluated for impairment | 279,786        | 232,054                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | 15,023                      | 1,650  | 528,513    |
| Ending Balance                              | $              | 301,478
$
233,206 
$
15,023 
$
1,650 
$
551,357
 

            Thefollowing table summarizes the impaired loans as of March 31, 2011 and December31, 2010:

*(Dollars in thousands)*

**March 31,		2011**

December 31,		2010

Balance of impaired loans with no allocated  allowance

** $               18,424**

 $                   10,016 

Balance of impaired loans with an allocated  allowance

**                     4,420**

                      15,077 

Total recorded investment in impaired loans

** $               22,844**

 $                   25,093 

 

** **

 

Amount of the allowance allocated to impaired loans

** $                 1,008**

 $                     2,912 

            

14

 

 
         The following table summarizes the impaired loans by loan type as of March 31,2011:
 

 

(Dollars in Thousands)

Recorded Investment 	with no allowance

Recorded Investment 	with allowance

Total Recorded 	Investment

Related 	Allowance

Commercial

 $                 17,625	

 $                     4,067	

 $             21,692	

 $                  950	

Residential real estate

                         799	

                           353	

 $               1,152	

                       58	

    Total

 $                 18,424	

 $                     4,420	

 $             22,844	

 $               1,008	

 

*Credit Quality Indicators.*As part of the on-going monitoring of the creditquality of the Bank’s loan portfolio, management tracks certain credit qualityindicators including trends related to (i) the weighted-average risk grade ofcommercial loans, (ii) the level of classified commercial loans, (iii) netcharge-offs, (iv) non-performing loans  and (v) the general economic conditionsin the State of Tennessee.

 

The Corporation uses a risk grading matrix to assign arisk grade to each of its commercials loans.  Loans are graded on a scale of 1 through8.  A description of the general characteristics of the eight risk grades is asfollows:

**Risk Rating 1        Minimal Risk**

 

General Characteristics:
-  	Substantially risk free
-  Federal, state, or municipalsubdivisions with acceptable investment grade credit rating.
-  Large national, regional, or localentity with proven access to capital markets.
-  Diversity in borrower’s line ofbusiness with stable and diversified sales base.
-  Borrower is considered to be anindustry leader with many consecutive years of strong profits and exhibits afinancial condition, equity position, liquidity, and debt service capacity farexceeding industry norms.
-  Borrower has an abundance ofunpledged financeable assets coupled with superior cash generationcapabilities.
-  Industry conditions and trends arepositive and strong.
-  Borrower has strong managementwith evidence of management succession.
-  A credit rating by Moody’s,Standard & Poor, or other qualified rating agency that is grade A orhigher.
-  A cash secured	loan with the cash on deposit in our Bank or a guaranty from the federal	government also warrants this risk rating.

**Risk Rating 2            Modest Risk**

** **

General Characteristics:
-  Borrower shows strongprofitability, liquidity, and capitalization better than industry norms and astrong market position in the region.
-  Borrower may have limited accessto public markets for short-term needs or capital requirements, but has readyaccess to alternative financing.
-  Loans may be unsecured based onthe financial strength of the borrower or secured by collateral that isconsidered liquid and marketable.
-  Borrower has a proven history ofprofitability and financial stability.
-  Borrower has a strong marketposition in its industry and has an abundance of financeable assets availableto protect the Bank’s position.
-  Borrower’s proven and steadymanagement with good management succession.
-  Borrower can withstand majormarket instabilities of short duration.
-  Credit rating by Moody’s, Standard& Poor, or other qualified rating agency that is grade BAA or higher. 

**Risk Rating 3            Average Risk**

** **

General Characteristics:

 
-  Borrower shows a stable earningshistory and financial condition in line with industry norms with indicationsthat these trends will continue.
-  The credit extension is consideredsound, however elements may be present which suggest the borrower may not befree from temporary impairments in the future.

 

15

 

 

 

 

 

 
-  Borrower’s liquidity and leverageis in line with industry norms.
-  Borrower has good management withacceptable management succession.
-  Under most economic and businessconditions, borrower has access to alternative financing but limited or noaccess to capital markets for short-term or capital needs.
-  Borrower may be an individual witha sound financial condition and liquidity with proven historical income torepay the debt as scheduled.
-  Credit extensions are generallysecured by acceptable collateral.

**Risk Rating 4            AcceptableRisk**

** **

General Characteristics:
-  Credit is to a borrower withsmaller margins of debt service coverage and with some elements of reducedfinancial strength.
-  Borrower is generally in a loweraverage market position in its industry.
-  Borrower shows satisfactory assetquality and liquidity, good debt capacity and coverage, and good management incritical positions.
-  Borrower’s management is ofunquestioned character but management succession may be questionable. 
-  Borrower can obtain similarfinancing from other financial institutions.
-  Interim losses or moderatelydeclining earnings trends may occur, but the borrower has sufficient strengthand financial flexibility to offset these issues.
-  Credit may be to individuals witha moderately leveraged financial condition but with satisfactory liquidity andincome to cover debt repayment requirements.
-  Business borrowers may havemoderate leverage, but must have historically consistent cash flow to coverdebt service and other operating needs.
-  Business borrowers may also haveerratic or cyclical operating performances but should demonstrate strong equitypositions to support these profitability swings.
-  Asset-based loans that havestabilized and proven performance with the financial capacity to provide forannual clean up may qualify for this rating.
-  Borrower has no access to capitalmarkets but would be financeable by another financial institution or financecompany.
-  Credit extensions are generallysecured by acceptable collateral.

**Risk Rating 5            Pass /Watch **

 

General Characteristics:

 

Loans considered for this risk rating require a heightened level ofsupervision.  

 

A) Transitional, Event Driven – This category of risk rated 5 loanscaptures responses to early warning signals from a relationship and, therefore,signifies a specific, event-driven, transitional credit grade. The event isgenerally something unplanned or unexpected such as a death, a disaster, theloss of a major client, product line, or key employee; divorce, or healthcondition of the owner or key management person. This category may be used intransitional upgrades as well as transitional downgrades of creditrelationships.  Under these criteria, this category necessitates a plan ofaction to either upgrade the credit to a “Pass” rating (i.e., Risk Rating 1-4),downgrade the credit to a criticized asset, or exit the relationship within sixmonths.

 

16

 

 

 

 

 

 

B) Ongoing Supervision Warranted**-**This category may also beutilized to identify loans having inherent characteristics which warrant morethan the normal level of supervision.  Loans meeting these criteria mayinclude larger, more complex loans with unusual structures.  Loans, which,due to structure or nature of the collateral require above average servicing,may also be considered for this risk rating.  Unlike other criteria listedpreviously for this category, these particular characteristics tend not to beone-time or transitional in nature; therefore, these loans may be expected toremain in this risk rating category longer than six months.  A loan mightremain in this risk rating category for its life or until the characteristicwarranting the rating can be eliminated or effectively mitigated.

            
-  Borrower may exhibit decliningearnings, strained cash flow, increasing leverage, or weakening marketpositions that indicate a trend toward an unacceptable risk.
-  Borrower’s liquidity, leverage,and earnings performance is below or trending below industry norms.
-  Interim losses and other adversetrends may occur but not to the level that would impair the Bank’s position. 
-  Borrower may be a newly formedcompany or in a new line of business or may be an established business with newor unproven management.  Borrower should be adequately capitalized, butmay not yet have achieved stabilized cash flow.
-  Borrower generally has a smallmarket position in its industry.
-  Borrower may be engaged in anindustry that is experiencing an economic downturn or is particularlysusceptible to uncontrollable external factors.
-  Borrower management is of goodcharacter although some management weakness may exist, including lack of depthor succession.
-  Borrower generally has limitedadditional debt capacity and modest coverage, and average or below-averageasset quality, margins, and market share.
-  Borrower’s ability to obtainfinancing from other financial institutions may be impaired.
-  Credit to individuals withmarginal financial condition and liquidity but with income still sufficient toservice the debt.

**Risk Rating 6               Special Mention**

 

A special mention asset has potential weaknesses that deservemanagement’s close attention. If left uncorrected, these potential weaknessesmay result in deterioration of the repayment prospects for the asset or in theinstitution’s credit position at some future date. Special mention assets arenot adversely classified and do not expose an institution to sufficient risk towarrant adverse classification.

** **

General Characteristics:
-  Borrower’s cash flow may not besufficient to fund anticipated cash needs.
-  Sufficiently or modestlysufficiently financeable assets are available to protect the Bank’s position. 
-  Adverse trends in borrower’s operations/profitsor unbalanced position in borrower’s balance sheet but not to the point whererepayment is in jeopardy.
-  Borrower generally shows limitedliquidity or high leverage.
-  Borrower’s financial position isin the lower quartile of industry norms.
-  Borrower’s business exhibits adeteriorating market position in the industry.
-  Borrower’s management lacks depthand succession.
-  Business is unable to withstandtemporary setbacks without affecting repayment capability.
-  Borrower is not financeable byanother bank but possibly by a finance company or specialized lender. 

**Risk Rating 7            Substandard**

 

A substandard asset is inadequately protected by the current soundworth and paying capacity of the obligor or of the collateral pledged, if any.Assets so classified must have a well-defined weakness, or weaknesses, thatjeopardize the liquidation of the debt. They are characterized by the distinctpossibility that the bank will sustain some loss if the deficiencies are notcorrected.

 

General Characteristics:
-  The primary source of borrower’srepayment no longer provides satisfactory support and repayment is dependant onsecondary sources.

 

 

17

 

 

 

 
-  A substandard loan is inadequatelyprotected by the current sound worth and paying capacity of the obligor or bythe collateral pledged, if any.
-  Normal repayment from the borroweris impaired although no loss of principal is envisioned.
-  A partial loss of interest orprincipal will occur if the borrower’s deficiencies are not corrected. 
-  Borrower’s cash flow is generallynot sufficient to fund anticipated cash needs.
-  Borrower’s financeable assets maynot be sufficient to protect the bank’s position.
-  Adverse trends in borrower’s operationsthat jeopardized debt repayment may require the borrower to undertake asignificant reorganization of financing or the business.
-  Borrower shows poor liquidity andhigh leverage impairing the repayment of the debt in accordance with agreedupon terms.
-  Borrower’s management lacks depthand succession; may be inexperienced or of questionable character.
-  Borrower’s market position in theindustry is deteriorating.
-  Borrower is not financeable byanother bank or finance company.

 

**Risk Rating 8       Doubtful**

** **

An asset classified doubtful has all the weaknesses inherent in oneclassified substandard with the added characteristic that the weaknesses makecollection or liquidation in full, on the basis of currently existing facts,conditions, and values, highly questionable and improbable.

** **

General Characteristics:
-  Inadequate primary source ofrepayment.  Assumes a less thansatisfactory secondary source of repayment on a most-likely case basis. There may be adequate secondary source of repayment on a best-case basis. 
-  Borrower has the same weaknessesfound in Substandard borrowers.
-  Loss probability is extremely highbut because of certain important and reasonably specific factors that may workto strengthen the loan, its classification as an estimated loss is deferreduntil a more exact status may be determined.
-  Pending factors may includeproposed merger or acquisition; liquidation procedures; capital injections;perfecting liens on additional collateral; and refinancing plans. 
-  Borrower’s cash flow isinsufficient to fund cash needs.
-  Borrower’s financeable assets areinsufficient to protect the bank’s position.
-  Borrower’s source of debt repaymentis dependant on liquidation of assets with a probable loss.
-  Borrower may no longer be a goingconcern, or may not exist as a going concern for the foreseeable future. 
-  No alternative financing sourcesexist for borrower.

** **

 

18

 

 

 

 

The following tables present risk grades and classified loans by class ofcommercial loan in the Bank’s portfolios as of March 31, 2011 (dollars inthousands):

 

 

Commercial Loan Portfolio:  Credit risk profile by  internally assigned grade

Commercial &		Industrial

Non-Farm,		Non-Residential 	Real Estate Loans

Construction &	Development

Commercial		Loans Secured 	By Residential R/E

All Other		Commercial Loans

Commercial		Totals

1-5  Pass

 $

49,841  

 $

137,195  

 $

32,758  

 $

8,726  

 $

40,949 

 $

269,469  

6- Special Mention

2,715  

5,022  

-  

456  

619  

8,812  

7- Substandard

3,671  

7,400  

1,670  

770  

1,248  

14,759  

8- Doubtful

4,153  

2,873  

-  

-  

1,412  

8,438  

**TOTALS**

** $**

**60,380 **

** $**

**152,490 **

** $**

**34,428 **

** $**

**9,952 **

** $**

**44,228 **

** $**

**301,478 **

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retail Loan Portfolio:  Credit risk profile based on delinquency status  Classification

Consumer		Loans

Single- Family		Residential**

All Other		Retail Loans

**Retail Totals**

 

 

  Performing

 $

13,357  

 $

207,513  

 $

24,759  

 $

245,630  

 

 

  Non-performing*

22  

3,834  

393  

4,249  

 

 

**TOTALS**

** $**

**13,380 **

** $**

**211,347 **

** $**

**25,152 **

** $**

**249,879 **

 

 

 

*Loans are classified as non-performing loans and are automaticallyplaced on non-accrual status once they reach 90 days past due

**Single-family residential loans includes primary liens, closed-endsecondary liens, residential construction loans, and home equity lines ofcredit

** **

**NOTE****7****–****RECENT ACCOUNTING PRONOUNCEMENTS**

** **

*ASU No. 2010-20, “Receivables (Topic 310) -Disclosures about the Credit Quality of Financing Receivables and the Allowancefor Credit Losses.” *ASU 2010-20requires entities to provide disclosures designed to facilitate financialstatement users’ evaluation of (i) the nature of credit risk inherent in theentity’s portfolio of financing receivables, (ii) how that risk is analyzed andassessed in arriving at the allowance for credit losses and (iii) the changesand reasons for those changes in the allowance for credit losses. Disclosuresmust be disaggregated by portfolio segment, the level at which an entitydevelops and documents a systematic method for determining its allowance forcredit losses, and class of financing receivable, which is generally adisaggregation of portfolio segment. The required disclosures include, amongother things, a rollforward of the allowance for credit losses as well asinformation about modified, impaired, non-accrual and past due loans and creditquality indicators. ASU 2010-20 became effective for the Corporation’sfinancial statements as of December 31, 2010, as it relates to disclosuresrequired as of the end of a reporting period. Disclosures that relate toactivity during a reporting period became effective for the Corporation’sfinancial statements beginning on January 1, 2011. ASU 2011-01, “Receivables(Topic 310) - Deferral of the Effective Date of Disclosures about Troubled DebtRestructurings in Update No. 2010-20,” temporarily deferred the effective datefor disclosures related to troubled debt restructurings to coincide with theeffective date of the then proposed ASU 2011-02, “Receivables (Topic 310) - ACreditor’s Determination of Whether a Restructuring Is a Troubled DebtRestructuring,” which is further discussed below.

 

*ASU No. 2010-28, “Intangibles - Goodwill and Other(Topic 350) - When to Perform Step 2 of the Goodwill Impairment Test forReporting Units with Zero or Negative Carrying Amounts.”*ASU 2010-28 modifies Step 1 of the goodwill impairmenttest for reporting units with zero or negative carrying amounts. For thosereporting units, an entity is required to perform Step 2 of the goodwillimpairment test if it is more likely than not that a goodwill impairmentexists. In determining whether it is more likely than not that a goodwillimpairment exists, an entity should consider whether there are any adversequalitative factors indicating that an impairment may exist such as if an eventoccurs or circumstances change that would more likely than not reduce the fairvalue of a reporting unit below its carrying amount. ASU 2010-28 becameeffective for the Corporation on January 1, 2011 and did not have a significantimpact on the Corporation’s financial statements.

 

*ASU No. 2011-02, “Receivables (Topic 310) - ACreditor’s Determination of Whether a Restructuring Is a Troubled DebtRestructuring.”*ASU 2011-02 clarifieswhich loan modifications constitute troubled debt restructurings and isintended to assist creditors in determining whether a modification of the termsof a receivable meets the criteria to be considered a troubled debtrestructuring, both for purposes of recording an impairment loss and fordisclosure of troubled debt restructurings. In evaluating whether arestructuring constitutes a troubled debt restructuring, a creditor mustseparately conclude, under the guidance clarified by ASU 2011-02, that both ofthe following exist: (a) the restructuring constitutes a concession; and (b)the debtor is experiencing financial difficulties. ASU 2011-02 will beeffective for the Corporation on July 1, 2011, and applies retrospectively torestructurings occurring on or after January 1, 2011. Adoption of ASU 2011-02 did not have a significant impact on the Corporation’sfinancial statements.

 

 

**Item 2.  Management'sDiscussion and Analysis of Financial Condition and Results of****Operations.**

** **

** **

19

 

 

**FORWARD-LOOKING STATEMENTS**

 

 

 

 

Certainstatements contained in this report may not be based on historical facts andare “forward-looking statements” within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the Securities ExchangeAct of 1934, as amended (the “Exchange Act”). These forward-looking statementsmay be identified by, among other things, the use of forward-lookingterminology such as “could,” “would,” “expects,” “believes,” “intends,”  “may”or “will,” or future or conditional verb tenses, and variations or  negativesof such terms.  These forward-looking statements include, without limitation,those relating to the Corporation’s valuation methodologies, fair value ofbonds, impairment of securities, repayment of loans, loan portfolio concentrations,fair value of impaired loans, satisfaction of capital adequacy requirements,payments on advances from the FHLB risk rating classifications of loans,adequacy of traditional sources of cash generated from operating activities tomeet liquidity needs and the realization of deferred income tax assets.  Wecaution you not to place undue reliance on such forward-looking statements inthis report because results could differ materially from those anticipated dueto a variety of factors.  These factors include, but are not limited to, conditionsin the financial market, liquidity needs, the sufficiency of our allowance forloan and lease losses (“ALLL”), economic conditions in the communities in theState of Tennessee where the Corporation does business, the impact ofgovernment regulation and supervision, interest rate risk, including changes inmonetary policy and fluctuating interest rates, the Corporation’s ability toattract and retain key personnel, competition from other financial services, otherfactors generally understood to affect the financial results of financialservices companies and other factors detailed from time to time in our filingswith the Securities and Exchange Commission (the “SEC”). We undertake noobligation to update these forward-looking statements to reflect events orcircumstances that occur after the date of this report.

 

**EXECUTIVE OVERVIEW**

 

AtMarch 31, 2011, the consolidated total assets of the Corporationwere $958.9 million, its consolidated net loans were $551.4 million, its totaldeposits were $814.8 million and its total shareholders' equity was $106.7million.  The Corporation’s loan portfolio at March 31, 2011 reflected adecrease of $7.8 million, or 1.4%, compared to December 31, 2010.  Totaldeposits increased $23.0 million, or 2.9%, and shareholders’ equity increasedby 0.4% during the first three months of 2011.  Total shareholders’ equityincludes an unrealized loss on available-for-sale securities of $842,000. 

 

**FINANCIALCONDITION**

** **

Averageearning assets for the quarter ended March31, 2011 were up 0.1%, or $1.2 million, from average earning assets for the quarterended December 31, 2010.  Average overnight investments for the quarter ended March 31, 2011were up 17.6% compared to December 31, 2010.  Average investment securities forthe quarter ended March 31, 2011 were up 6.0% compared to December 31, 2010.  Averagetotal assets of $952.4 million for the quarter ended March 31, 2011decreased 0.1% or approximately $816,000, compared to $953.2 million for the quarter ended December 31, 2010.  

 

**Securities**

 

Available-for-salesecurities are an integral part of the asset/liability management process  theBank, the Corporation’s sole direct subsidiary.  Accordingly, they represent animportant source of liquidity available to fund loans and accommodate assetreallocation strategies dictated by changes in the Bank’s operating and taxplans, shifting yield spread relationships and changes in configuration of theyield curve.  At March 31, 2011, the Bank's investment securities portfolio had$265.9 million available-for-sale securities, which are valued at fair marketvalue, and $38.6 million held-to-maturitysecurities, which are valued at cost on the balance sheet. These compare to$236.2 million of available-for-sale securities and $40.0 million ofheld-to-maturity securities as of December 31, 2010.  

 

**Loans and Loan Losses**

 

*Allowance for Possible Loan Losses.*The allowance for possible loan losses is a reserve established througha provision for possible loan losses charged to expense, which representsmanagement’s best estimate of probable losses that have been incurred withinthe existing portfolio of loans. The allowance, in the judgment of management,is necessary to reserve for estimated loan losses and risks inherent in theloan portfolio. The Corporation’s allowance for possible loan loss methodology includes allowance allocations calculated inaccordance with ASC Topic 310, “Receivables” (“ASC Topic 310”) and allowanceallocations calculated in accordance with ASC Topic 450, “Contingencies” (“ASCTopic 450”). Accordingly, the methodology is based on historical loss experienceby type of credit and internal risk grade, specific homogeneous risk pools andspecific loss allocations, with adjustments for current events and conditions.The Corporation’s process for determining the appropriate level of the allowance for possible loan losses is designedto account for credit deterioration as it occurs. The provision for possibleloan losses reflects loan quality trends, including the levels of and trendsrelated to non-accrual loans, past due loans, potential problem loans,criticized loans and net charge-offs or recoveries, among other factors. Theprovision for possible loan losses also reflects the totality of actions takenon all loans for a particular period. In other words, the amount of the provision reflects not only thenecessary increases in the allowance for possible loan losses related to newlyidentified criticized loans, but it also reflects actions taken related toother loans including, among other things, any necessary increases or decreasesin required allowances for specific loans or loan pools.  

 

20

 

 

 

 

 

 

 

The level of the allowance reflects management’scontinuing evaluation of industry concentrations, specific credit risks, loanloss experience, current loan portfolio quality, present economic, politicaland regulatory conditions and unidentified losses inherent in the current loanportfolio. Portions of the allowance may be allocated for specific credits;however, the entire allowance is available for any credit that, in management’sjudgment, should be charged off. While management utilizes its best judgmentand information available, the ultimate adequacy of the allowance is dependentupon a variety of factors beyond the Corporation’s control, including, amongother things, the performance of the Corporation’s loan portfolio, the economy,changes in interest rates and the view of the regulatory authorities towardloan classifications. 

 

The Corporation’s allowance for possible loan lossesconsists of three elements: (i) specific valuation allowances determined inaccordance with ASC Topic 310 based on probable losses on specific loans; (ii)historical valuation allowances determined in accordance with ASC Topic 450based on historical loan loss experience for similar loans with similarcharacteristics and trends, adjusted, as necessary, to reflect the impact ofcurrent conditions; and (iii) general valuation allowances determined inaccordance with ASC Topic 450 based on general economic conditions and otherqualitative risk factors both internal and external to the Corporation.  

 

The allowances established for probable losses onspecific loans are based on a regular analysis and evaluation of problem loans.Loans are classified based on an internal credit risk grading process thatevaluates, among other things: (i) the obligor’s ability to repay; (ii) theunderlying collateral, if any; and (iii) the economic environment and industryin which the borrower operates. This analysis is performed at the relationshipmanager level for all commercial loans. When a loan has a calculated grade of 10 or higher, a special assets officeranalyzes the loan to determine whether the loan is impaired and, if impaired,the need to specifically allocate a portion of the allowance for possible loanlosses to the loan. Specific valuation allowances are determined by analyzingthe borrower’s ability to repay amounts owed, collateral deficiencies, therelative risk grade of the loan and economic conditions affecting theborrower’s industry, among other things.

 

Historical valuation allowances are calculated basedon the historical loss experience of specific types of loans and the internalrisk grade of such loans at the time they were charged-off. The Corporationcalculates historical loss ratios for pools of similar loans with similarcharacteristics based on the proportion of actual charge-offs experienced tothe total population of loans in the pool. The historical loss ratios are periodicallyupdated based on actual charge-off experience. A historical valuation allowance is established for eachpool of similar loans based upon the product of the historical loss ratio andthe total dollar amount of the loans in the pool. The Corporation’s pools ofsimilar loans include similarly risk-graded groups of commercial and industrialloans, commercial real estate loans, consumer real estate loans and consumerand other loans.

 

General valuation allowances are based on generaleconomic conditions and other qualitative risk factors both internal andexternal to the Corporation. In general, such valuation allowances aredetermined by evaluating, among other things: (i) the experience, ability andeffectiveness of the bank’s lending management and staff; (ii) theeffectiveness of the Corporation’s loan policies, procedures and internalcontrols; (iii) changes in asset quality; (iv) changes in loan portfolio volume; (v) the composition and concentrations of credit;(vi) the impact of competition on loan structuring and pricing; (vii) theeffectiveness of the internal loan review function; (viii) the impact ofenvironmental risks on portfolio risks; and (ix) the impact of rising interestrates on portfolio risk. Management evaluates the degree of risk that each oneof these components has on the quality of the loan portfolio on a quarterlybasis. Each component is determined to have either a high, moderate or low degree of risk. The results are theninput into a “general allocation matrix” to determine an appropriate generalvaluation allowance.

 

21

 

 

 

 

 

 

            Included in the general valuation allowances are allocations forgroups of similar loans with risk characteristics that exceed certainconcentration limits established by management. Concentration risk limits havebeen established, among other things, for certain industry concentrations, largebalance and highly leveraged credit relationships that exceed specified riskgrades, and loans originated with policy exceptions that exceed specified riskgrades. 

 

Loans identified as losses by management, internalloan review and/or bank examiners are charged-off. Furthermore, consumer loanaccounts are charged-off automatically based on regulatory requirements.

** **

            The following table summarizes the allocation in theallowance for loan and lease losses by loan segment for the year ended March31, 2011 (dollars in thousands):  

 

 

** **

**Residential**

**Consumer &**

** **

** **

 

**Commercial**

**real estate**

**other retail**

**Unallocated**

**Totals**

Beginning balance 

 $

6,915  

 $

2,001  

 $

408  

 $

96  

 $

9,420  

  Less: Charge-offs

(2,157)

(244)

(96)

-  

(2,497)

  Add: Recoveries

38  

1  

7  

-  

46  

  Add: Provisions

798  

(35)

(40)

2  

725  

Ending balance 

** $**

**5,594 **

** $**

**1,723 **

** $**

**279 **

** $**

**98 **

** $**

**7,694 **

 

 

 

 

 

 

 

** **

**Residential**

**Consumer &**

** **

** **

 

**Commercial**

**real estate**

**other retail**

**Unallocated**

**Totals**

Loans individually evaluated for impairment

 $

887  

 $

121  

 $

-  

 $

-  

 $

1,008  

Loans collectively evaluated for impairment

4,707  

1,602  

279  

98  

6,686  

Ending balance

** $**

**5,594 **

** $**

**1,723 **

** $**

**279 **

** $**

**98 **

** $**

**7,694 **

 

The following table summarizes the changes in theallowance for loan and lease losses for the years ended March 31, 2011 andDecember 31, 2010 (dollars in thousands):  

 

**March 31, 2011**

December 31, 2010

Balance at beginning of period

** $**

**9,420 **

 $

8,929  

Provision (reduction) charged (credited) to  operating expenses

**725 **

1,896  

Charge-offs:

** **

 

     Commercial and industrial

**(2,157)**

(2,046)

     Real estate

**(244)**

(108)

     Consumer and other

**(96)**

(77)

          Total charge-offs

**(2,497)**

(2,231)

Recoveries:

** **

 

     Commercial and industrial

**38 **

782  

     Real estate

**1 **

-  

     Consumer and other

**7 **

44  

          Total recoveries

**46 **

826  

Balance at end of year

** $**

**7,694 **

 $

9,420  

 

 

The loan portfolio is the largest component of earningassets for the Bank and, consequently,provides the largest amount of revenue for the Corporation.  The loan portfolioalso contains the highest exposure torisk as a result of the possibility of unexpected deterioration in the creditquality of borrowers.  When analyzing potential loans, management of the Bankassesses both interest rate objectives and credit quality objectives indetermining whether to make a given loan and the appropriate pricing for thatloan.  All loans are expected to be repaid from cash flow or proceeds from thesale of selected assets of the borrowers.  Collateral requirements for the loanportfolio are based on credit evaluation of the borrowers.

 

22

 

 

 

 

 

 

Loanvolume was fairly stagnant during the first quarter 2011, with slight declinesreported in all segments of the portfolio.  Retain loans declined $3.8 millionthrough the first three months of 2011, and residential first mortgages decline$3.1 million.  The commercial portfolio declined by $4.2 million, as there werea few loans that paid off or were refinanced.  Commercial loan demand remainsmodest as the economy struggles to recover.  

 

TheBank continues to reserve more heavily against its construction and developmentportfolio than any other segment of the commercial portfolio, given thecomparatively high level of losses that have been incurred within this segmentof the portfolio over the previous year.  Additionally, higher reserves arebeing placed against property types which are perceived to be higher risk, suchas retail and multi-family real estate.  

 

Aformal process is in place to enhance control over the underwriting of loansand to monitor loan collectability.  This process includes education andtraining of personnel about the Bank's loan policies and procedures, assignmentof  credit analysts to support lenders, timely identification of loans withadverse characteristics, control of corrective actions and objective monitoringof loan reviews.  The Special Assets Department of the Bank identifies andmonitors assets that need special attention.  At March 31, 2011, this processidentified loans totaling $8.8 million, that were classified as other assetsespecially mentioned compared to loans totaling $10.8 million at December 31,2010.  Loans totaling $14.8 million were classified as substandard at March 31, 2011,compared to loans totaling $20.0 million at December 31, 2010.  Loans totaling$8.4 million were classified as doubtful at March31, 2011, compared to $6.7 million atDecember 31, 2010. 

 

             Loans having recorded investments of $22.8 million and$25.1 million at March 31, 2011 and December 31, 2010 have been identified asimpaired.  However, loans amounting to $13.9 million and $8.3 million at March31, 2011 and December 31, 2010, respectively, were not accruing interest inaccordance with the provision of Financial Accounting Standards Board (“FASB”)Accounting Standards Codification (“ASC”) Topic 310-40, Troubled DebtRestructurings by Creditors (“ASC Topic 310”).  Interest received on theseloans during first quarter of 2011 was approximately $255,000, and during 2010was approximately $619,000.  The gross interest income that would have beenrecorded if the loans had been current in accordance with their original termsand had been outstanding throughout the period or since origination, if heldfor part of the period, was approximately $326,000, and $958,000 for the periodending March 31, 2011 and December 31, 2010, respectively. The Bank had noloans that were 90 days or more past due that were not included in nonaccrualloans as of March 31, 2011.

 

            The Bank had $15.1 million****that qualified as“troubled debt restructurings” as defined in ASC Topic 310 as of March 31,2011. Troubled debt restructurings are loans for which the Bank, for economicor legal reasons related to a borrower’s financial difficulties, grants aconcession to the borrower which would otherwise not be considered.  For aloan to be classified as a troubled debt restructuring, the borrower must beexperiencing financial difficulties (even if it is not currently in default onany of its indebtedness), and because of  those difficulties the Bank must havemade a concession that would otherwise not be granted.  These concessionscan take many forms, including but not limited to granting temporary paymentrelief, restructuring a loan to extend the amortization or lower the requiredpayment amount, and forgiveness of principal.  Likewise, the financialdifficulty being experienced by a borrower can take many forms, including butnot limited to:
-  Being in default on any existingindebtedness;
-  Declaring, or being in the processof declaring, bankruptcy;
-  Significant doubt as to whether anexisting business can continue to operate as a going concern;
-  Historically demonstrating, or forecasting,insufficient cash flows with which to service all debt in a timely manner; or 
-  Absent the modification, theborrower cannot continue to keep all indebtedness current. 

 

Once identified as a troubled debt restructuring, thebank will track these loans and periodically report to the Board of Directorsthe aggregate balances thereof.  

 

             

23

 

 

 

 

The following table shows a breakdown of all loan modifications:

 

 

 

 

 

 

March 31, 2011

December 31, 2010

(Dollars in Thousands)

Number of 	Contracts

Outstanding 	recorded investment

Number of 	Contracts

Outstanding 	recorded investment

Troubled Debt Restructurings

 

 

 

 

     Residential - prime

                      7

 $        1,101

                    7

 $            1,180

     Consumer - other

                    31

                 13,947

                   30

                  13,644

 

Number of 	Contracts

Recorded 	investment

Number of 	Contracts

Recorded 	investment

Troubled Debt Restructurings That  Subsequently Defaulted:

 

 

 

 

     Residential - prime

                      2

           $           506

                      1

    $                 28

     Consumer - other

                      5

                     4,476

                     4

                       796

 
**Deposits**

 

            The Bank does not have any foreign offices and all depositsare serviced in its 17 domestic offices.  The Bank's average deposits increased0.7% during the first three months of 2011 compared to an increase of 3.9% inthe first three months of 2010.  Average total noninterest-bearing depositswere 15.6% of total deposits at March 31,2011, contributing to the Bank's low costof deposits, compared to 14.6% at December 31, 2010.

** **

**RegulatoryRequirements for Capital**

 

TheCorporation and the Bank are subject to federal regulatory risk-adjustedcapital adequacy standards.  Failure to meet capital adequacy requirementscould result in certain mandatory, and possibly additional discretionary,actions by regulators that could have a direct material adverse effect on thefinancial condition of the Corporation and the Bank.  Federal regulationsrequire the Corporation and the Bank to meet specific capital adequacyguidelines that involve quantitative measures of assets, liabilities andcertain off-balance-sheet items as calculated under regulatory accountingpractices.  The capital classification is also subject to qualitative judgmentsby the regulators about components, risk weightings and other factors.

 

            Under federal regulatory standards, to be“well-capitalized,” the Corporation’s and the Bank’s Tier 1 Risk-Based CapitalRatio (ratio of Tier 1 Capital to risk-weighted assets) must be at least 6%,its Total Risk-Based Capital Ratio (ratio of total capital to risk-weightedassets) must be at least 10%, and its Tier 1 Leverage Capital Ratio (ratio ofTier 1 Capital to average assets) must be at least 5%.  Equity capital (net ofcertain adjustments for intangible assets and investments in non-consolidatedsubsidiaries and certain classes of preferred stock) and other certain equitylike instruments are considered Tier 1 Capital.  Tier 2 Capital consists ofcore capital plus supplementary or temporary capital such assubordinated debt, some types of preferred stock, and a defined percentage ofthe allowance for possible loan and lease****losses.

 

            As of March 31, 2011,the Bank's Tier 1 Risk-Based Capital Ratio, Total Risk-Based Capital Ratio andTier 1 Leverage Capital Ratios were 15.0%, 15.0%, and 10.2%, respectively,compared to 14.6%, 15.8%, and 10.1% at December 31, 2010. At March 31, 2011, theCorporation's Tier 1 Risk-Based Capital Ratio, Total Risk-Based Capital Ratioand Tier 1 Leverage Capital Ratios were 15.1%, 16.3% and 10.4%, respectively. The ratios were 15.0%, 16.2% and 10.4%, respectively, at December 31, 2010. Management believes, as of March 31, 2011, that the Corporation and the Bank each met allcapital adequacy requirements to which they are subject.

 

 

 

24

 

 

 

 

**LIQUIDITYAND CAPITAL****RESOURCES**

 

 

            Most of the capital needs of the Bank historically have beenfinanced with retained earnings and deposits received, and the Corporation'sprimary source of liquidity has been dividends declared by the Bank.  

 

            The Bank issubject to Tennessee statutes and regulations that impose restrictions on theamount of dividends that may be declared.  Furthermore, any dividend paymentsare subject to the continuing ability of the Bank to maintain its compliancewith minimum federal regulatory capital requirements and to retain itscharacterization under federal regulations as a “well-capitalized”institution.  The Bank’s Board of Directors has adopted a liquidity policy thatoutlines specific liquidity target balances.  Compliance with this policy isreviewed quarterly by the Bank’s Asset/Liability Committee and results are reportedto the Bank’s Board of Directors. 

 

TheBank’s formal asset and liability management process is used to manage interestrate risk and assist management in maintaining reasonable stability in thegross interest margin as a result of changes in the level of interest ratesand/or the spread relationships among interest rates.  The Bank uses anearnings simulation model to evaluate the impact of different interest ratescenarios on the gross margin.  Each quarter, the Bank’s Asset/LiabilityCommittee monitors the relationship of rate sensitive earning assets to ratesensitive interest-bearing liabilities (interest rate sensitivity), which isthe principal factor in determining the effect that fluctuating interest rateswill have on future net interest income.  Rate sensitive earning assets andinterest bearing liabilities are financial instruments that can be repriced tocurrent market rates within a defined time period.

 

Managementbelieves that the Corporation’s traditional sources of cash generated from theBank’s operating activities are adequate to meet the Corporation’s liquidityneeds for normal ongoing operations; however, the Bank also has access toadditional capital, if necessary, through additional advances from the FHLB orthe Cash Management Advance Line of Credit Agreement with the FHLB.  In March2008, the Bank obtained five advances at $7.0 million each from the FHLB.  Thefirst three scheduled repayment of the advances were made in March 2009, March2010 and March 2011 and an additional payment of $3.1 million was made inSeptember 2010.  The remaining payments will continue each March through2013.   In September 2008, the Bank obtained two additional advances of $3.1million each for a total borrowing in 2008 of $41.2 million.  The borrowingsfrom the FHLB have been used generally for investment strategies to enhance theBank’s portfolio.   Please refer to Note 4 in the notes to consolidatedfinancial statements for additional information about borrowings from the FHLBand the repayment schedule of such borrowings.

 

 

**CRITICALACCOUNTING POLICIES**

 

Theaccounting principles the Bank follows and the methods of applying theseprinciples conform with accounting principles generally accepted in the UnitedStates and with general practices within the banking industry.  In connectionwith the application of those principles, the Bank’s management has madejudgments and estimates that with respect to the determination of the ALLL andthe recognition of deferred income tax assets, have been critical to thedetermination of the Corporation’s financial position, results of operationsand cash flows.  

 

*Allowance for Loan andLease Losses*

 

           The Bank’smanagement assesses the adequacy of the ALLL prior to the end of each month andprepares a more formal review quarterly to assess the risk in the Bank's loanportfolio.  This assessment includes procedures to estimate the allowance andtest the adequacy and appropriateness of the resulting balance.  The ALLLrepresents calculated amounts for specifically identified credit exposure andexposures readily predictable by historical or comparative experience.  Eventhough this calculation considers specific credits, the entire allowance isavailable to absorb any credit losses. 

 

25

 

 

 

 

 

 

           These calculated amounts are determined by assessing loansidentified as not in compliance with loan agreements.  These loans aregenerally in two different risk groups.  One group is unique loans(commercial loans, including those loans considered impaired).  The secondgroup consists of pools of homogenous loans (generally retail and mortgageloans).  The calculation for unique loans is based primarily on risk ratinggrades assigned to each of these loans as a result of the Bank’s loan managementand review processes.  Each risk-rating grade is assigned a loss ratio,which is determined based on the experience of management, discussions withbanking regulators and the independent loan review process.  The amountallocated for an impaired loan is based on estimated cash flows discounted atthe loan's original effective interest rate or the underlying collateral value. Historical data, including actual loss experience on specific types ofhomogenous loans, is used to allocate amounts for loans or groups of loansmeeting the specified criteria.  Management has implemented procedures thatgive more detailed historical data by category of retail and consumer credit andperformance characteristics to broaden the analysis and improve monitoring ofpotential credit risk.

 

           Criteriaconsidered and processes utilized in evaluating the adequacy of the ALLL are:
-  Portfolio quality trends;
-  Changes in the nature and volumeof the portfolio;
-  Present and prospective economicand business conditions, locally and nationally;
-  Management review systems and boardoversight, including external loan review processes;
-  Changes in credit policy, creditadministration, portfolio management and procedures;
-  Changes in personnel, managementand staff; and
-  Existence and effect of anyconcentrations of credit.

           In assessing theadequacy of the ALLL, the risk characteristics of the entire loan portfolio areevaluated.  This process includes the judgment of the Bank’s management, inputfrom independent loan reviews and reviews that may have been conducted by bankregulators as part of their usual examination process.

 

*Deferred Income Tax Assets*

 

Asof March 31, 2011, the deferred income tax asset was $7.0 million and wasincluded with other assets on the balance sheet.  Deferred income tax assetsconsist mainly of the tax effect of excess provisions for loan and lease****lossesover actual losses incurred and deferred compensation.  Management believesthat it is more likely than not that these assets will be realized in futureyears.

** **

**RESULTSOF OPERATIONS**

 

Totalinterest income for the first three months of 2011 was $9.5 million compared to$10.0 million for the first three months of 2010.   Interest and fees earned onloans and investments are the components of total interest income.  Interestand fees earned on loans were $7.5 million, a decrease of approximately$337,000, or 4.3%, during the first three months of 2011 compared to the firstthree months of 2010.  Nominal interest earned on investment securities andother investments was $1.9 million, a decrease of approximately $221,000, or10.4%, during the first three months of 2011 compared to the first three monthsof 2010.  The decrease in nominal interest earned on investment securities andother investments was primarily the result of market conditions.   

 

            Total interestexpense in the first three months of 2011 was $1.4 million, a decrease of$555,000, or 28.8%, compared to the first three months of 2010.  The lowerinterest rates for certificates of deposits and public funds during the firstquarter of 2011 were the primary reason for the lower expense.  As a policy,budgeted financial goals are monitored on a quarterly basis by the Bank’sAsset/Liability Committee, which reviews the actual dollar change in netinterest income for different interest rate movements.  A negative dollarchange in net interest income for a 12-month and 24-month period of less than10.0% of net interest income given a 100 to 200 basis point shift in interest rates is considered an acceptablerate risk position.  The rate risk analysis for the 24-month period beginningApril 30, 2011 and ending March 31, 2012 showed a worst-case potential changeto net interest income, in the very unlikely event of a negative 100 basispoint shift in interest rates, of 2.7%, or a decrease in net interest income of$894,000 by the end of the period.

 

26

 

 

 

 

            Net interestincome of the Corporation on a fully taxable equivalent basis is influencedprimarily by changes in:

(1)           the volume and mix of earningassets and sources of funding;

(2)           market rates of interest; and

(3)           income tax rates.

 

 

 

 

 

            The impact ofsome of these factors can be controlled by management policies and actions. External factors also can have a significant impact on changes in net interestincome from one period to another.  Some examples of such factors are:

(1)           the strength of credit demands bycustomers;

(2)           Federal Reserve Board monetarypolicy; and

(3)           fiscal and debt managementpolicies of the federal government, including changes in tax laws.

 

            The netinterest margin, on a tax equivalent basis, at March 31, 2011, March 31, 2010 andDecember, 31, 2010 was 4.09%, 4.11% and 4.13%, respectively.

 

            Additions ofapproximately $725,000 were made to the provision for possible loan and leaselosses in the first quarter of 2011 as a result of an increase in the level ofcredit losses on both secured and unsecured consumer loans as well as the Bankhaving to downgrade the credit level on a few commercial loans.  

                                                                                                                                                                 

            The followingtable presents the Bank’s analysis of the Allowance for Loan and Lease Lossactivity:

 

 

**March 31, 2011**

December 31, 2010

Balance at beginning of period

** $**

**9,420  **

 $

8,929   

Provision (reduction) charged (credited) to  operating expenses

**725 **

1,896   

Charge-offs:

** **

 

     Commercial and industrial

**(2,157)**

(2,046)

     Real estate

**(244)**

(108)

     Consumer and other

**(96)**

(77)

          Total charge-offs

**(2,497)**

(2,231)

Recoveries:

** **

 

     Commercial and industrial

**38  **

782   

     Real estate

**1  **

-   

     Consumer and other

**7  **

44   

          Total recoveries

**46  **

826   

Balance at end of year

** $**

**7,694  **

 $

9,420   

** **

 

            Noninterest income was $2.4 million, a decrease of approximately$416,000, or 14.6%, during the first three months of 2011 compared to the firstthree months of 2010.  The gain on sales of available for sale securities,which was approximately $60,000 in the first three months of 2011 compared toapproximately $503,000 in the first three months of 2009, was the primary reasonfor the decrease.  

 

            Noninterest expense, excluding the provision forpossible loan and lease losses was $725,000, a decrease of approximately$361,000, or 33.2%, in the first three months of 2011 as compared to the firstthree months of 2010.  Reasons for thelower noninterest expense in the first three months of 2011 were thatadvertising, office supplies and computer expense were less than the previousthree months in 2010.

 

            

 

** **

** **

27

 

 

           The Bank also leases a certain number of its properties.  There was nochange during the three-month period ended March 31, 2011 in the terms of these leases.

 

Netincome for the three months ended March31, 2011 and the three months ended March 31, 2011 was $1.5 million and $1.2 million.  A reduction in noninterest expense along with lessprovision expense contributed tothe three month increase.  The Corporation earned $0.28 per share for the threemonths ended in 2011, and $0.22 per share for the three months ended in 2010.  

 

 

 

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

TheBank is a party to financial instruments with off-balance-sheet risk in thenormal course of business to meet the financing needs of its customers.  Thesefinancial instruments include commitments to extend credit and stand-by lettersof credit.  These instruments involve, to varying degrees, elements of creditrisk in excess of the amount recognized in the balance sheet.  The contract ornotional amounts of those instruments reflect the extent of involvement theBank has in those financial instruments.  Loan commitments are agreements tolend to a customer as long as there is not a violation of any conditionestablished in the loan commitment contract.  Stand-by letters of credit areconditional commitments issued by the Bank to guarantee the performance of acustomer to a third party.  Those guarantees are primarily issued to supportpublic and private borrowing arrangements, including commercial paper, bondfinancing and similar transactions.  The credit risk involved in issuingletters of credit is essentially the same as that involved in making a loan.

 

Thetotal outstanding balance of loan commitments and stand-by letters of credit inthe normal course of business at March31, 2011 were $94.9 million and $8.7million, respectively.

 

AtMarch 31, 2011, the Corporation and the Bank did not have anyoff-balance sheet arrangements other than commitments to extend credit andstand-by letters of credit.

** **

**Item 3.  Quantitativeand Qualitative Disclosures About Market Risk.**

** **

Duringthe three months ended March 31, 2011,there were no material changes in the quantitative and qualitative disclosuresabout market risk presented in the Corporation's Annual Report on Form 10-K forthe year ended December 31, 2010. 

** **

**Item 4.  Controls andProcedures.**

 

(a) Evaluation ofDisclosure Controls and Procedures.  The Corporation, with theparticipation of its management, including the Corporation’s Chief ExecutiveOfficer and  reasurer (principal financial officer), carried out an evaluationof the effectiveness of the design and operation of its disclosure controls andprocedures (as defined in Rules 13a-15 and 15d-15 under the Exchange Act) as ofthe end of the period covered by this report.  Based upon that evaluation andas of the end of the period covered by this report, the Corporation’s ChiefExecutive Officer and Treasurer (principal financial officer) concluded thatthe Corporation’s disclosure controls and procedures were effective in ensuringthat information required to be disclosed in its reports that the Corporationfiles or submits to the SEC under the Exchange Act is recorded, processed,summarized and reported on a timely basis.

 

(b) Changes in InternalControl Over Financial Reporting.  There has been no change in theCorporation's internal control over financial reporting that occurred duringthe first quarter of 2011 that has materially affected, or is reasonably likelyto materially affect, the Corporation's internal control over financialreporting.

** **

** **

28

 

 

 

 

 

**PART II - OTHER INFORMATION**

** **

**Item1A. Risk Factors.**

 

Therehave been no material changes in the risk factors previously disclosed in theCorporation’s Annual Report on Form 10-K for the year ended December 31, 2010.

** **

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

** **

Thefollowing table provides information regarding purchases of the Corporation’scommon stock made by the Corporation during the first quarter of 2011:

 

**CORPORATION’S PURCHASES OF EQUITY SECURITIES**

**Period**

**Total		Number of 	Shares	Purchased**

**Average Price		Paid per Share**

**Total Number of		Shares Purchased 	as Part of Publicly  	Announced Plans or Programs**

**Maximum Number (or		Approximate Dollar 	Value) of  Shares that 	May Yet Be Purchased 	Under the Plans or 	Programs**

January 1, 2011 –  	January  31, 2011

––

––

––

––

February 1, 2011 –  	February 28, 2011

––

––

––

––

March1, 2011 –		March 31,  2011

 34,540*

$30.57

––

––

Total

34,540

$30.57

––

––

 

       *Represents 25,000shares purchased from several third-party sellers pursuant to negotiated agreements to purchase and 9,540 shares purchased inconnection with the settlement of a dispute involving a Bank customer’s estate.

** **

 

**Item 6.  Exhibits.**

 
EXHIBIT
 
		NUMBER
DESCRIPTION
3.1
Charter. (1)
3.2
Articles of Amendment to Charter. (1)
3.3
Second Amended and Restated By-laws. (2)
31.1
Certification of the ChiefExecutive Officer of First Farmers and Merchants Corporation Pursuant to Rule13a-14 of the Securities Exchange Act of 1934, as amended, as Adopted Pursuantto Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of the AssistantTreasurer (principal financial officer) of First Farmers and Merchants CorporationPursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended, asAdopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of the ChiefExecutive Officer and Assistant Treasurer (principal financial officer) ofFirst Farmers and Merchants Corporation Pursuant to 18 U.S.C. Section 1350, asAdopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

                              

(1)  Incorporated byreference from the First Farmers and Merchants Corporation Amendment No. 1 tothe Annual Report on Form 10-K/A for the year ended December 31, 2003, as filedwith the Securities and Exchange Commission on May 7, 2004 (File Number000-10972).

 

(2) Incorporated by reference from the First Farmers and Merchants CorporationAnnual Report on Form 10-K, as filed with the Securities and ExchangeCommission on March 15, 2011 (File Number 000-10972).

 

29

 

 

**SIGNATURES**

 

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 

 

 

FIRST FARMERS AND MERCHANTS CORPORATION

(Registrant)

 

 

 

 
Date             May 5, 2011
                    /s/ T. Randy Stevens                                
 
T. Randy Stevens,Chief Executive Officer
 
 
 
 
 
 
 
 
Date             May 5, 2011
             /s/ Patricia P. Bearden                                      
 
PatriciaP. Bearden, Treasurer (principal financial officer and principalaccounting officer)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

30

 

 

 

 
EXHIBIT
 
		NUMBER
DESCRIPTION
3.1
Charter. (1)
3.2
Articles of Amendment to Charter. (1)
3.3
Second Amended and Restated By-laws. (2)
31.1
Certification of the ChiefExecutive Officer of First Farmers and Merchants Corporation Pursuant to Rule13a-14 of the Securities Exchange Act of 1934, as amended, as Adopted Pursuantto Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of the AssistantTreasurer (principal financial officer) of First Farmers and Merchants CorporationPursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as amended, asAdopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of the ChiefExecutive Officer and Assistant Treasurer (principal financial officer) ofFirst Farmers and Merchants Corporation Pursuant to 18 U.S.C. Section 1350, asAdopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

                              

(1)  Incorporated byreference from the First Farmers and Merchants Corporation Amendment No. 1 tothe Annual Report on Form 10-K/A for the year ended December 31, 2003, as filedwith the Securities and Exchange Commission on May 7, 2004 (File Number000-10972).

 

(2) Incorporated by reference from the First Farmers and Merchants CorporationAnnual Report on Form 10-K, as filed with the Securities and ExchangeCommission on March 15, 2011 (File Number 000-10972).

 

 

 

 

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