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**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Markone)**

 

**x  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For the quarterly period ended September 30,2008.**

 

**or**

 

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

 

**For thetransition period from                              to**

 

**CommissionFile Numbers: 000-10972**

 

**First Farmers and MerchantsCorporation**

(Exact name of registrant as specified in its charter)

 

| **Tennessee**  (State or other jurisdiction of incorporation or organization) |   | **62-1148660**  (I.R.S. Employer Identification No.) |
|-------------------------------------------------------------------------------|--------|------------------------------------------------------|
|                                                                          |   |                                                 |
| **816 South Garden Street  Columbia, Tennessee**                              |   | **38402-1148**                                       |
| (Address  of principal executive offices)                                     |   | (Zip  Code)                                          |

 

**931-388-3145**

(Registrant’stelephone number, including area code)

 

 

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

 

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

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,a non-accelerated filer, or a smaller 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-accelerated  filer  ̈ (Do not check if a smaller reporting  company)           Smaller  reporting company  ̈ |

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Act).  ̈ Yes xNo

 

Indicate the number ofshares outstanding of each of the registrant’s classes of common stock, as ofthe latest practicable date.

5,605,000 shares of common stock as of November 7,2008

 

 

 

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**PART I - FINANCIAL INFORMATIO**N

 

**Item 1.Financial Statements.**

 

The following unaudited consolidated financialstatements of the Registrant and its subsidiaries are included in this Report:

 
| Consolidated balance sheets –  September 30, 2008 and December 31, 2007                                               |   |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                                                                 |   |   |
| Consolidated statements of  income - For the three months and nine months ended September 30, 2008  and September 30, 2007 |   |   |
|                                                                                                                                 |   |   |
| Consolidated statements of  cash flows - For the nine months  ended September 30, 2008 and September 30, 2007              |   |   |
|                                                                                                                                 |   |   |
| Selected  notes to consolidated financial statements                                                                                 |   |   |

 

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| **FIRST  FARMERS AND MERCHANTS CORPORATION AND SUBSIDIARIES  CONSOLIDATED BALANCE SHEETS** |
|--------------------------------------------------------------------------------------------|

 
| **(Dollars in Thousands, Except Per Share Data) **                                                                                                                  | ** ** | **September 30,  2008  (Unaudited)** | ** **  | **December 31,  2007  (1)** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|-------------|----------------------------------|------------|
| **ASSETS**                                                                                                                                                                                             |       |                                      | ** **  |                             |       |
| Cash and due  from banks                                                                                                                                                                               | ** ** | **$**                                     | **19,721**  | ** **                       | $          | 35,097 |   |
| Interest-bearing  due from banks                                                                                                                                                                       | ** ** | **1,540**                                 | ** **  | 176                              |       |
| Federal funds  sold                                                                                                                                                                                    | ** ** | **25,025**                                | ** **  | 600                              |       |
| Total cash and  cash equivalents                                                                                                                                                                       | ** ** | **46,286**                                | ** **  | 35,873                           |       |
| Securities                                                                                                                                                                                             |       |                                      | ** **  |                             |       |
| Available-for-sale  (amortized cost $167,867 and $163,050, respectively)                                                                                                                               |       | **165,848**                               | ** **  | 163,911                          |       |
| Held-to-maturity  (fair market value $63,126 and $76,460, respectively)                                                                                                                                |       | **63,305**                                | ** **  | 75,565                           |       |
| Total Securities                                                                                                                                                                                       | ** ** | **229,153**                               | ** **  | 239,476                          |       |
| Loans, net of  deferred fees                                                                                                                                                                           | ** ** | **557,770**                               | ** **  | 500,143                          |       |
| Allowance for  loan losses                                                                                                                                                                             | ** ** | **(7,356**                                | **)**       | (7,381                           | )          |
| Net loans                                                                                                                                                                                              | ** ** | **550,414**                               | ** **  | 492,762                          |       |
| Bank premises  and equipment, at cost less allowance for depreciation                                                                                                                                  |       | **16,066**                                | ** **  | 14,306                           |       |
| Core deposit and  other intangibles                                                                                                                                                                    | ** ** | **9,205**                                 | ** **  | 9,318                            |       |
| Other assets                                                                                                                                                                                           | ** ** | **32,841**                                | ** **  | 31,311                           |       |
| TOTAL ASSETS                                                                                                                                                                                           | ** ** | **$**                                     | **883,965** | ** **                       | $          | 823,046 |   |
|                                                                                                                                                                                                   |       |                                      | ** **  |                             |       |
| **LIABILITIES**                                                                                                                                                                                        |       |                                      | ** **  |                             |       |
| Deposits                                                                                                                                                                                               |       |                                      | ** **  |                             |       |
| Noninterest-bearing                                                                                                                                                                                    | ** ** | **$**                                     | **117,656** | ** **                       | $          | 131,043 |   |
| Interest-bearing  (including certificates of deposits over $100: 2008 - $108,759; 2007 -  $107,398)                                                                                                    |       | **601,574**                               | ** **  | 567,916                          |       |
| Total deposits                                                                                                                                                                                         | ** ** | **719,230**                               | ** **  | 698,959                          |       |
| Federal funds  purchased and securities sold under agreements to repurchase                                                                                                                            |       | **1,652**                                 | ** **  | 2,507                            |       |
| Dividends  payable                                                                                                                                                                                     | ** ** | **—**                                | ** **  | 1,991                            |       |
| Short-term  borrowings                                                                                                                                                                                 | ** ** | **600**                                   | ** **  | 600                              |       |
| Accounts payable  and accrued liabilities                                                                                                                                                              | ** ** | **14,650**                                | ** **  | 12,650                           |       |
| Federal Home  Loan Bank Advances                                                                                                                                                                       | ** ** | **41,177**                                | ** **  | —                           |       |
| Minority interest  in consolidated subsidiary                                                                                                                                                          | ** ** | **95**                                    | ** **  | 95                               |       |
| TOTAL  LIABILITIES                                                                                                                                                                                     | ** ** | **777,404**                               | ** **  | 716,802                          |       |
| **SHAREHOLDERS’  EQUITY**                                                                                                                                                                         |       |                                      | ** **  |                             |       |
| Common stock -  $10 par value per share, 8,000,000 shares authorized; 5,605,000 and 5,680,000  shares****issued and outstanding as of  September 30,2008 and December 31, 2007, respectively |       | **56,050**                                | ** **  | 56,800                           |       |
| Retained  earnings                                                                                                                                                                                     | ** ** | **51,752**                                | ** **  | 48,916                           |       |
| Accumulated  other comprehensive income                                                                                                                                                                | ** ** | **(1,241**                                | **)**       | 528                              |       |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                                                                                                                       | ** ** | **106,561**                               | ** **  | 106,244                          |       |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                       | ** ** | **$**                                     | **883,965** | ** **                       | $          | 823,046 |   |

 

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| (1) Derived from audited financial statements.                                |   |
|------------------------------------------------------------------------------------|--------|
|                                                                               |   |
| The accompanying notes are an integral part of  consolidated financial statements. |   |

 

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| ** **

**FIRST FARMERS AND MERCHANTS  CORPORATION AND SUBSIDIARIES  CONSOLIDATED STATEMENTS OF INCOME** |
|--------------------------------------------------------------------------------------------------------------|

 
| **(Dollars in Thousands, Except Per Share Data)****(Unaudited)** | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **2008**                                                                                       | ** ** | **2007**                                             | ** ** | **2008**                                            | ** ** | **2007** | ** ** |
|                                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| **INTEREST  AND DIVIDEND INCOME**                                                              |       |                                                 | ** ** | ** **                                          |       |   | ** ** | ** ** |   |
| Interest and  fees on loans                                                                    |       | **$**                                                | **8,202**  |                                                | $          | 8,489 | ** ** | **$** | **24,680** |   | $ | 24,755 |   |
| Income on  investment securities                                                               |       |                                                 |       |                                                |       |   |   |   |   |
| Taxable interest                                                                               |       | **1,690**                                            |       | 1,251                                               |       | **4,991** |   | 3,849 |   |
| Exempt from  federal income tax                                                                | ** ** | **924**                                              |       | 970                                                 | ** ** | **2,882** |   | 2,951 |   |
| Dividends                                                                                      | ** ** | **4**                                                |       | 49                                                  | ** ** | **110** |   | 156 |   |
| ** **                                                                                     |       | **2,618**                                            | ** ** | 2,270                                               |       | **7,983** |   | 6,956 |   |
| Other interest  income                                                                         | ** ** | **106**                                              |       | 249                                                 | ** ** | **234** |   | 844 |   |
| TOTAL INTEREST  INCOME                                                                         | ** ** | **10,926**                                           |       | 11,008                                              | ** ** | **32,897** |   | 32,555 |   |
|                                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| **INTEREST  EXPENSE**                                                                          |       |                                                 | ** ** | ** **                                          |       |   | ** ** | ** ** |   |
| Interest on  deposits                                                                          |       | **2,749**                                            |       | 4,041                                               | ** ** | **9,014** |   | 12,005 |   |
| Interest on  other short term borrowings                                                       | ** ** | **279**                                              |       | 27                                                  | ** ** | **523** |   | 100 |   |
| TOTAL INTEREST  EXPENSE                                                                        | ** ** | **3,028**                                            |       | 4,068                                               | ** ** | **9,537** |   | 12,105 |   |
| NET INTEREST  INCOME                                                                           | ** ** | **7,898**                                            |       | 6,940                                               | ** ** | **23,360** |   | 20,450 |   |
| PROVISION FOR  POSSIBLE LOAN AND LEASE LOSSES                                                  | ** ** | **50**                                               |       | —                                              | ** ** | **50** |   | — |   |
| NET INTEREST  INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES                                 | ** ** | **7,848**                                            |       | 6,940                                               | ** ** | **23,310** |   | 20,450 |   |
|                                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| **NONINTEREST  INCOME**                                                                        |       |                                                 | ** ** | ** **                                          |       |   | ** ** | ** ** |   |
| Trust department  income                                                                       |       | **625**                                              |       | 640                                                 | ** ** | **1,882** |   | 1,989 |   |
| Service fees on  deposit accounts                                                              |       | **2,002**                                            |       | 1,929                                               | ** ** | **5,839** |   | 5,634 |   |
| Other fees and  commissions                                                                    | ** ** | **91**                                               |       | 172                                                 | ** ** | **328** |   | 468 |   |
| Other operating  income                                                                        | ** ** | **416**                                              |       | 205                                                 | ** ** | **828** |   | 701 |   |
| Securities gains                                                                               | ** ** | **177**                                              |       | —                                              | ** ** | **1,305** |   | — |   |
| TOTAL  NONINTEREST INCOME                                                                      | ** ** | **3,311**                                            |       | 2,946                                               | ** ** | **10,182** |   | 8,792 |   |
|                                                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| **NONINTEREST  EXPENSE**                                                                       |       |                                                 | ** ** | ** **                                          |       |   | ** ** | ** ** |   |
| Salaries and  employee benefits                                                                |       | **4,279**                                            |       | 4,057                                               | ** ** | **12,858** |   | 11,578 |   |
| Net occupancy  expense                                                                         |       | **670**                                              |       | 596                                                 | ** ** | **1,910** |   | 1,691 |   |
| Furniture and  equipment expense                                                               | ** ** | **249**                                              |       | 250                                                 | ** ** | **752** |   | 788 |   |
| Other operating  expenses                                                                      | ** ** | **2,674**                                            |       | 2,384                                               | ** ** | **8,174** |   | 7,510 |   |
| TOTAL  NONINTEREST EXPENSES                                                                    | ** ** | **7,872**                                            |       | 7,287                                               | ** ** | **23,694** |   | 21,567 |   |
| INCOME BEFORE  PROVISION FOR INCOME TAXES                                                      | ** ** | **3,287**                                            |       | 2,599                                               | ** ** | **9,798** |   | 7,675 |   |
| PROVISION FOR  INCOME TAXES                                                                    | ** ** | **450**                                              |       | 511                                                 | ** ** | **1,696** |   | 1,494 |   |
| NET INCOME                                                                                     | ** ** | **$**                                                | **2,837**  |                                                | $          | 2,088 | ** ** | **$** | **8,102** |   | $ | 6,181 |   |
| **BASIC  EARNINGS PER SHARE**                                                                  |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted Average  Shares Outstanding                                                           |       | **5,619,027**                                        |       | 5,715,228                                           | ** ** | **5,662,544** |   | 5,736,182 |   |
| ** **                                                                                     |       | **$**                                                | **0.50**   | ** **                                          | $          | 0.37 |   | **$** | **1.43** |   | $ | 1.08 |   |

 
| 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** |
|------------------------------------------------------------------------------------------------------|

 
| **(Dollars in Thousands)  (Unaudited)**                                 | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                        | **2008**   | ** **                                              | **2007**   | ** ** |
| **OPERATING  ACTIVITIES**                                                         |       |                                                    |       |   |   |
| Net income                                                                        | ** ** | **$**                                                   | **8,102**  | ** ** | $ | 6,181 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities |       |                                                    | ** ** |   |   |
| Excess  (deficiency) of provision for possible loan losses over net charge-offs   |       | **(25**                                                 | **)**      | 102 |   |
| Provision for  depreciation and amortization of premises and equipment            |       | **763**                                                 | ** ** | 755 |   |
| Securities gains                                                                  | ** ** | **(1,305**                                              | **)**      | — |   |
| Loss from  disposition of other real estate                                       | ** ** | **300**                                                 | ** ** | — |   |
| Amortization of  deposit base intangibles                                         | ** ** | **113**                                                 | ** ** | 479 |   |
| Amortization of  investment security premiums, net of accretion of discounts      |       | **223**                                                 | ** ** | 444 |   |
| Increase in cash  surrender value of life insurance contracts                     | ** ** | **(1,141**                                              | **)**      | (320 | ) |
| (Increase)  decrease in Deferred income taxes                                     |       | **(304**                                                | **)**      | (318 | ) |
| Interest  receivable                                                              | ** ** | **568**                                                 | ** ** | (182 | ) |
| Other assets                                                                      | ** ** | **446**                                                 | ** ** | (284 | ) |
| Increase  (decrease) in Interest payable                                          |       | **(1,035**                                              | **)**      | (248 | ) |
| Other  liabilities                                                                | ** ** | **2,767**                                               | ** ** | 2,303 |   |
| Total  adjustments                                                                | ** ** | **1,370**                                               | ** ** | 2,731 |   |
| Net cash  provided by operating activities                                        | ** ** | **9,472**                                               | ** ** | 8,912 |   |
| **INVESTING  ACTIVITIES**                                                         |       |                                                    | ** ** |   |   |
| Proceeds from  maturities, calls, and sales of available-for-sale securities      |       | **109,290**                                             | ** ** | 35,073 |   |
| Proceeds from  maturities and calls of held-to-maturity securities                | ** ** | **11,991**                                              | ** ** | 5,313 |   |
| Purchases of  investment securities Available-for-sale                            |       | **(112,755**                                            | **)**      | (29,491 | ) |
| Net increase in  loans                                                            | ** ** | **(57,627**                                             | **)**      | (23,094 | ) |
| Proceeds from  sale of other real estate                                          | ** ** | **406**                                                 | ** ** |   |   |
| Purchase of life  insurance premium                                               | ** ** | **(696**                                                | **)**      | (1,410 | ) |
| Purchases of  premises and equipment                                              | ** ** | **(2,523**                                              | **)**      | (3,434 | ) |
| Net cash used in  investing activities                                            | ** ** | **(51,914**                                             | **)**      | (17,043 | ) |
| **FINANCING  ACTIVITIES**                                                         |       |                                                    | ** ** |   |   |
| Net increase  (decrease) in noninterest-bearing and interest-bearing deposits     |       | **20,271**                                              | ** ** | (3,811 | ) |
| Net increase  (decrease) in short term borrowings                                 | ** ** | **(855**                                                | **)**      | (277 | ) |
| Proceeds from  FHLB borrowings                                                    | ** ** | **41,177**                                              | ** ** |   |   |
| Proceeds from  sale of minority interest in a controlled subsidiary               | ** ** | **—**                                              | ** ** | 95 |   |
| Repurchase of  Common Stock                                                       | ** ** | **(3,750**                                              | **)**      | (2,984 | ) |
| Cash dividends                                                                    | ** ** | **(3,988**                                              | **)**      | (3,947 | ) |
| Net cash  provided by (used in) financing activities                              | ** ** | **52,855**                                              | ** ** | (10,924 | ) |
| Increase  (decrease) in cash and cash equivalents                                 | ** ** | **10,413**                                              | ** ** | (19,055 | ) |
| Cash and cash  equivalents at beginning of period                                 | ** ** | **35,873**                                              | ** ** | 74,981 |   |
| Cash and cash  equivalents at end of period                                       | ** ** | **$**                                                   | **46,286** | ** ** | $ | 55,926 |   |

 

The accompanying notesare an integral part of the consolidated financial statements.

 

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**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1 - OTHER INFORMATION**

 

The interim unauditedconsolidated financial statements of First Farmers and Merchants Corporation(the “Corporation”) presented in this report have been prepared on a consistentbasis and in accordance with the instructions to Form 10-Q and do notinclude all of the information and notes required by U.S. generally acceptedaccounting principles for complete financial statements.  In the opinion of management, all adjustmentsconsidered necessary for a fair presentation have been included.  These adjustments were of a normal, recurringnature and consistent with U.S. generally accepted accounting principles.  For further information, refer to theconsolidated financial statements and notes included in the Corporation’sAnnual Report on Form 10-K for the year ended December 31, 2007.

 

**NOTE 2 – STOCK REPURCHASE**

 

Duringthe third quarter of 2008, the Corporation repurchased, through negotiatedtransactions with third-party sellers, 19,643 shares of the Corporation’scommon stock at a price of $50 per share for an aggregate purchase price ofapproximately $982,000.

 

**NOTE 3 – FAIR VALUEMEASUREMENT**

 

InSeptember 2006, the Financial Accounting Standards Board (the “FASB”)issued Statement of Financial Accounting Standard (“SFAS”) No. 157, “FairValue Measurements” (“SFAS 157”), which defines fair value, establishes aframework for measuring fair value in U.S. generally accepted accountingprinciples and expands disclosures about fair value measurements.  SFAS 157 applies only to fair-valuemeasurements that are already required or permitted by other accounting standardsand is expected to increase the consistency of those measurements.  The definition of fair value focuses on theexit price (i.e., the price that would be received to sell an asset or paid totransfer a liability in an orderly transaction between market participants atthe measurement date) not the entry price (i.e., the price that would be paidto acquire the asset or received to assume the liability at the measurementdate).  The statement emphasizes thatfair value is a market-based measurement rather than an entity-specificmeasurement.  Therefore, the fair valuemeasurement should be determined based on the assumptions that marketparticipants would use in pricing the asset or liability.  The effective date for SFAS No. 157 isfor fiscal years beginning after November 15, 2007, and interim periodswithin those fiscal years.  TheCorporation adopted SFAS 157 effective January 1, 2008.

 

InFebruary of 2007, the FASB issued SFAS No. 159, “The Fair ValueOption for Financial Assets and Financial Liabilities” (“SFAS 159”), whichgives entities the option to measure eligible financial assets and financialliabilities at fair value on an instrument by instrument basis, that areotherwise not permitted to be accounted for at fair value under otheraccounting standards. The election to use the fair value option is availablewhen an entity first recognizes a financial asset or financial liability.Subsequent changes in fair value must be recorded in earnings. This statementis effective as of the beginning of a company’s first fiscal year after November 15,2007. The adoption of SFAS 159 did not have a significant impact on theCorporation’s consolidated financial statements. The Corporation also adoptedSFAS 159 effective January 1, 2008, but did not elect the fair valueoption for any financial instrument not presently being accounted for at fairvalue.

 

The Corporation and itswholly-owned subsidiary, First Farmers and Merchants Bank (the “Bank”), has anestablished process for determining fair values. Fair value is based uponquoted market prices, where available. If listed prices or quotes are notavailable, fair value is based upon internally developed models or processesthat use primarily market-based or independently-sourced market data, includinginterest rate yield curves, option volatilities and third party information.Valuation adjustments may be made to ensure that financial instruments arerecorded at fair value. These adjustments include amounts to reflectcounterparty credit quality (for financial assets reflected at fair value), theBank’s creditworthiness (for financial liabilities reflected at fair value),liquidity and other unobservable parameters that are applied consistently overtime as follows:

 

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| · | Credit valuation  adjustments are necessary when the market price (or parameter) is not  indicative of the credit quality of the counterparty;                                                                                                                                                                                                                                       |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                 |
| · | Debit valuation  adjustments are necessary to reflect the credit quality of the Bank in the  valuation of liabilities measured at fair value;                                                                                                                                                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                                 |
| · | Liquidity valuation  adjustments are necessary when the Bank may not be able to observe a recent  market price for a financial instrument that trades in inactive (or less  active) markets or to reflect the cost of exiting larger-than-normal  market-size risk positions; and                                                                                                    |
|   |                                                                                                                                                                                                                                                                                                                                                                                 |
| · | Unobservable parameter  valuation adjustments are necessary when positions are valued using  internally developed models that use as their basis unobservable parameters –  that is, parameters that must be estimated and are, therefore, subject to  management judgment to substantiate the model valuation. These financial  instruments are normally traded less actively. |

 

The methods describedabove may produce a fair value calculation that may not be indicative of netrealizable value or reflective of future fair values. Furthermore, whilemanagement of the Corporation believes that the Corporation’s valuation methodsare appropriate and consistent with other market participants, the use ofdifferent methodologies or assumptions to determine the fair value of certainfinancial instruments could result in a different estimate of fair value at thereporting date.

 

**ValuationHierarchy**

 

SFAS 157 establishes athree-level valuation hierarchy for disclosure of fair value measurements. Thevaluation hierarchy is based upon the transparency of inputs to the valuationof an asset or liability as of the measurement date. The three levels aredefined as follows:

 
| · | Level 1 – inputs to the  valuation methodology are quoted prices (unadjusted) for identical  assets or liabilities in active markets;                                                                                                                                               |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                          |
| · | Level 2 – inputs to the  valuation methodology include quoted prices for similar assets and  liabilities in active markets, and inputs that are observable for the asset  or liability, either directly or indirectly, for substantially the full term  of the financial instrument; and |
|   |                                                                                                                                                                                                                                                                                          |
| · | Level 3 – inputs to the  valuation methodology are unobservable and significant to the fair value  measurement.                                                                                                                                                                          |

 

A financial instrument’scategorization within the valuation hierarchy is based upon the lowest level ofinput that is significant to the fair value measurement.  Below is a description of the valuationmethodologies used for instruments measured at fair value, as well as thegeneral classification of such instruments pursuant to the valuation hierarchy.

 

**Assets**

 

*Securities*- Where quoted prices are available in an active market, securities areclassified within level 1 of the valuation hierarchy. Level 1 securitiesinclude highly liquid government bonds, federal funds sold and certain otherproducts. If quoted market prices are not available, then fair values areestimated by using pricing models, quoted prices of securities with similarcharacteristics, or discounted cash flows. Examples of such instruments, whichwould generally be classified within level 2 of the valuation hierarchy,include the Corporation’s available-for-sale investment securities portfolio.In certain cases where there is limited activity or less transparency aroundinputs to the valuation, securities are classified within level 3 of thevaluation hierarchy. At September 30, 2008, the Corporation had nosecurities classified within level 3.

 

*Impairedloans* — A loan is considered to be impaired when it isprobable the Bank will be unable to collect all principal and interest paymentsdue in accordance with the contractual terms of the loan agreement.  Individually identified impaired loans aremeasured based on the present value of expected payments using the loan’soriginal effective 

 

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rates as the discountrate, the loan’s observable market price, or the fair value of the collateralif the loan is collateral dependent.  Ifthe recorded investment in the impaired loans exceeds the measure of fairvalue, a valuation allowance may be established as a component of the allowancefor loan losses.  Impaired loans areclassified within the level 3 of the hierarchy.

 

*Otherassets* – Included in other assets are certain assets carriedat fair value, including the cash value of Bank-owned life insurancepolicies.  The carrying amount of theseassets is based on information received from the insurance carriers indicatingthe financial performance of the policies and the amount the Bank would receiveshould the policies be surrendered.  TheBank reflects these investments within level 2 of the valuation hierarchy.

 

**Liabilities**

 

*Securitiessold under repurchase agreements (“repurchase agreements”), federal fundspurchased and other borrowings -* At September 30, 2008,all of the Bank’s repurchase agreements, federal funds purchased and otherborrowings (overnight borrowings from the Federal Home Loan Bank) are settledon a short-term basis, usually daily.  Asa result, the fair value of the instruments approximates their carrying amountand classified such liabilities as level 2 within the valuation hierarchy.

 

*Otherliabilities –* The Bank has certain liabilities carried atfair value.  These include futureobligations pursuant to a supplemental retirement plan and proceeds ofsplit-dollar life insurance policies. For these obligations, the Bank discounts the anticipated future cashflows using current interest rates. These liabilities are classified as level 2 within the valuationhierarchy.

 

The following tablepresents the financial instruments carried at fair value as of September 30,2008, by caption on the consolidated balance sheet and by SFAS 157 valuationhierarchy (as described above) (dollars in thousands):

 

**Assets and liabilities measured atfair value on a recurring basis as of September 30, 2008**

 
| ** **                                   | ** ** | **Total carrying  value in the   consolidated   balance sheet** | ** ** | **Quoted market  prices in an   active market  (Level 1)** | ** ** | **Internal   models with   significant   observable market   parameters  (Level 2)** | ** ** | **Internal   models with   significant   unobservable market   parameters  (Level 3)** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|
| Federal funds  sold                          |       | $                                                                                             | 25,025     |                                                                                     | $          | 25,025                                                                                                                  |       | $                                                                                                                         | —     |   | $ | — |   |
| Available-for-sale  securities               |       | 165,848                                                                                       |       | —                                                                                   |       | 165,848                                                                                                                 |       | —                                                                                                                    |       |
| Other assets                                 |       | 19,663                                                                                        |       | —                                                                                   |       | 19,663                                                                                                                  |       | —                                                                                                                    |       |
| **Total  assets at fair value**              |       | $                                                                                             | 210,536    |                                                                                     | $          | 25,025                                                                                                                  |       | $                                                                                                                         | 185,511    |   | $ | — |   |
| Securities sold  under repurchase agreements |       | $                                                                                             | 1,652      |                                                                                     | $          | —                                                                                                                  |       | $                                                                                                                         | 1,652      |   | $ | — |   |
| Other  liabilities                           |       | 5,509                                                                                         |       | —                                                                                   |       | 5,509                                                                                                                   |       | —                                                                                                                    |       |
| **Total  liabilities at fair value**         |       | $                                                                                             | 7,161      |                                                                                     | $          | —                                                                                                                  |       | $                                                                                                                         | 7,161      |   | $ | — |   |

 

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The Corporation may be required, from time to time, tomeasure certain assets at fair value on a nonrecurring basis in accordance withgenerally accepted accounting principles. These include assets that are measured at the lower of cost or marketthat were recognized at fair value below the cost at the end of theperiod.  The following table presents thefinancial instruments carried at fair value as of September 30, 2008, bycaption on the consolidated balance sheets and by SFAS 157, valuation hierarchy(as described above):

 

**Assets and liabilities measured atfair value on a nonrecurring basis as of September 30, 2008**

 
| ** **                           | ** ** | **Total carrying  value in the   consolidated   balance sheet** | ** ** | **Quoted market  prices in an   active market  (Level 1)** | ** ** | **Internal  models with  significant  observable  market   parameters  (Level 2)** | ** ** | **Internal models   with significant   unobservable   market   parameters  (Level 3)** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|
| Impaired Loans                       |       | $                                                                                             | 11,996     |                                                                                     | $          | —                                                                                            |       | $                                                                                                                         | —     |   | $ | 11,996 |   |
| **Total  assets at fair value**      |       | $                                                                                             | 11,996     |                                                                                     | $          | —                                                                                            |       | $                                                                                                                         | —     |   | $ | 11,996 |   |
|                                 |       |                                                                                          |       |                                                                                     |       |                                                                                              |       |                                                                                                                      |       |
| Other  liabilities                   |       | $                                                                                             | —     |                                                                                     | $          | —                                                                                            |       | $                                                                                                                         | —     |   | $ | — |   |
| **Total  liabilities at fair value** |       | $                                                                                             | —     |                                                                                     | $          | —                                                                                            |       | $                                                                                                                         | —     |   | $ | — |   |

 

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

 

TheBank has a Blanket Agreement for Advances and Security Agreement (the “BlanketAgreement”) with the Federal Home Loan Bank of Cincinnati (the “FHLB”).  Advances made to the Bank under the BlanketAgreement are collateralized by the FHLB stock and unidentified qualifyingresidential mortgage loans totaling 150% of the outstanding amount borrowed.These collateralization matters are outlined in the Blanket Agreement dated March 31,2008 between the Bank and the FHLB.

 

Scheduledannual principal maturities of borrowings under this credit line as of September 30,2008 for the next five years are as follows:

 
| 2009  |   | $          | 7,000,000  |   |
|-------|--------|------------|------------|--------|
| 2010  |   | 10,077,052 |       |
| 2011  |   | 7,000,000  |       |
| 2012  |   | 7,000,000  |       |
| 2013  |   | 10,100,000 |       |
| Total |   | $          | 41,177,052 |   |

 

Stockheld in the FHLB totaling $2.9 million at September 30, 2008 is carried atcost.  The stock is restricted and canonly be sold back to the FHLB at par.

 

TheBank also has a Cash Management Advance (the “CMA”) Line of Credit Agreementdated September 30, 2008 with the Federal Home Loan Bank.  The CMA is a component of the BlanketAgreement.  The purpose of the CMA is toassist with short-term liquidity management. Under the terms of the CMA, the Bank may borrow a maximum of$40,000,000, selecting a variable rate of interest for up to 90 days or a fixedrate for a maximum of 30 days.  Therewere no borrowings outstanding under the CMA Line of Credit as of September 30,2008.

 

**NOTE 5- RECENT ACCOUNTING PRONOUNCEMENTS**

 

In September 2006,the FASB ratified the consensus the Emerging Issues Task Force (the “EITF”)reached regarding EITF Issue No. 06-4, “Accounting for DeferredCompensation and Postretirement Benefit Aspects of Endorsement Split-DollarLife Insurance Arrangements” (“EITF 06-4”), which provides accounting guidancefor postretirement benefits related to endorsement split-dollar life insurancearrangements, whereby the employer owns and controls the insurance policies.The consensus concludes that an employer should recognize a liability for thepostretirement benefit in accordance with SFAS No. 106, “Employers’Accounting for Postretirement Benefits Other 

 

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Than Pensions” (“FAS 106”),or Accounting Principles Board Opinion No. 12, “Omnibus Opinion-1967” (“APB12”). In addition, the consensus states that an employer should also recognizean asset based on the substance of the arrangement with the employee.EITF 06-4 is effective for fiscal years beginning after December 15,2007.

 

In March 2007, theFASB ratified the consensus the EITF reached regarding EITF Issue No. 06-10,“Accounting for Collateral Assignment Split-Dollar Life Insurance Arrangements”(“EITF 06-10”), which provides accounting guidance for postretirement benefitsrelated to collateral assignment split-dollar life insurance arrangements,whereby the employee owns and controls the insurance policies. The consensusconcludes that an employer should recognize a liability for the postretirementbenefit in accordance with FAS 106 or APB 12, as well as recognize anasset based on the substance of the arrangement with the employee.EITF 06-10 is effective for fiscal years beginning after December 15,2007. The Corporation and the Bank adopted EITF 06-4 and 06-10 on January 1,2008, and the effect of adoption on the consolidated financial statements was areduction in retained earnings of approximately $268,000 and an increase inaccrued liabilities of approximately $268,000.

 

In September 2006,the FASB ratified the consensus reached by the EITF on Issue 06-5, “Accountingfor Purchases of Life Insurance-Determining the Amount That Could Be Realizedin Accordance with FASB Technical Bulletin No. 85-4, Accounting forPurchases of Life Insurance” (“EITF 06-5”). The effective date of EITF 06-5 isfor fiscal years beginning after December 15, 2006. The EITF concludedthat a policyholder should consider any additional amounts included in thecontractual terms of the policy in determining the amount that could berealized under the insurance contract. Amounts that are recoverable by thepolicyholder at the discretion of the insurance company should be excluded fromthe amount that could be realized. The Company adopted EITF 06-5 effective January 1,2007. The adoption of EITF 06-5 had no effect on the Company’s consolidatedbalance sheets or consolidated statements of income.

 

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**Item 2.  Management’s Discussionand Analysis of Financial Condition and Results of Operations.**

 

**FORWARD-LOOKINGSTATEMENTS**

 

Certain statements contained in this report may notbe based on historical facts and are “forward-looking statements” within themeaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended. These forward-lookingstatements may be identified by, among other things, the use of forward-lookingterminology such as “could,” “expects,” “believes,” “may” or “will,” or futureor conditional verb tenses, and variations or negatives of such terms.  These forward-looking statements include,without limitation, those relating to fair value methodologies anddeterminations, the potential sale of available-for-sale securities, loanportfolio concentrations and diversifications, reserves against loan portfoliosegments, repayment of loans by borrowers, exposure to commercial borrowers inthe construction and development industries, satisfaction of capital adequacyrequirements, the repayment of borrowings from the Federal Home Loan Bank of Cincinnati (the “FHLB”), adequacy of capital resources and traditional sources of cashgenerated from operating activities to meet liquidity needs, the effect offluctuating interest rates, the realization of deferred income tax assets andinternal control over financial reporting. We caution you not to place undue reliance on such forward-lookingstatements in this report because results could differ materially from thoseanticipated due to a variety of factors. These factors include, but are not limited to, changes in economicconditions; fluctuations in prevailing interest rates and the effectiveness ofour risk monitoring systems; the ability of our borrowers to repay loans;adverse changes in our special mention credits; our ability to sellavailable-for-sale securities to fund increased loan demand; our ability tomeet regulatory capital adequacy requirements; our ability to meet liquidityneeds from operating activities; the accuracy of assumptions in our rate riskanalysis; our ability to recognize deferred tax assets; our ability to maintaincredit quality; laws and regulations affecting financial institutions ingeneral; our ability to control factors influencing net interest income; thegeographic concentration of our assets; our ability to maintain sufficientasset quality and cost controls; and other factors generally understood toaffect the financial results of financial services companies and other factorsdetailed from time to time in our filings with the Securities and ExchangeCommission. We undertake no obligation to update these forward-lookingstatements to reflect events or circumstances that occur after the date of thisreport.

 

**EXECUTIVE OVERVIEW**

 

AtSeptember 30,2008, the consolidated total assets of First Farmers and MerchantsCorporation (the “Corporation”) were $883.9 million, its consolidated net loanswere $550.4 million, its total deposits were $719.2 million and its totalshareholders’ equity was $106.6 million. The loan portfolio at September 30, 2008 reflected an increase of$57.6 million, or 11.7%, compared to December 31, 2007.  Total deposits increased $20.2 million andshareholders’ equity increased 0.3% during the first nine months of 2008.

 

**FINANCIAL CONDITION**

 

Averageearning assets at September 30,2008 were up 5.9%, or $42.7 million, from average earning assets at December 31,2007.  Average overnight investments at September 30, 2008 were down $4.7million compared to December 31, 2007. Average investment securities at September 30, 2008 were up 5.8% compared tothe average at December 31, 2007. Average total assets of $842.2 million at September 30, 2008 increased 5.6% or $45.0million, compared to $797.2 million at December 31, 2007.

 

**Securities**

 

Thesecurities portfolio of First Farmers and Merchants Bank (the “Bank”), theCorporation’s sole direct subsidiary, is an integral part of itsasset/liability management process. These securities represent an important source of liquidity available tofund loans and accommodate asset reallocation strategies dictated by changes inthe Bank’s operating and tax plans, shifting yield spread relationships andchanges in configuration of the yield curve. At September 30, 2008, the 

 

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Bank’sinvestment securities portfolio held $165.8 million of available-for-salesecurities, which are valued at fair market value, and $63.3 million ofheld-to-maturity securities, which are valued at cost on the balance sheet.These compare to $163.9 million of available-for-sale securities and $75.6million of held-to-maturity securities as of December 31, 2007. At September 30,2008, the amortized cost of approximately $167.9 million securities in theavailable-for-sale category exceeded the fair market value by $2.0million.  These securities arepredominantly securities issued by municipalities and mortgage-backedsecurities.  The losses are due tooverall increases in the market interest rates subsequent to purchase.  The Corporation has the ability and theintent to hold these securities for a period of time sufficient to recover allgross unrealized losses.  Accordingly,the Corporation has not recognized any other-than-temporary impairment forthese securities.

 

**Loans**

 

Theloan portfolio is the largest component of earning assets for the Bank and, consequently, provides the highestamount of revenues for the Corporation. The loan portfolio also contains the highestexposure to risk as a result of the possibility of unexpected deterioration inthe credit quality of borrowers.  Whenanalyzing potential loans, management of the Bank assesses both interest rateobjectives and credit quality objectives in determining whether to make a givenloan and the appropriate pricing for that loan.

 

Thevast majority of the Bank’s outstanding loans continue to be housed in theMaury and Lawrence Country portfolios. These two counties now account for 78.6% of total loans in the Bank’sloan portfolio, which is down from 79.5% at June 30, 2008.  The unemployment rate in five of the Bank’sseven counties has worsened over the past 12 months.  Overall, the softness in the general economyis being felt throughout the markets that the Bank serves, which increases thecredit risk of the loan portfolio.

 

Althoughthere is not an industry concentration as measured by regulatory guidelineswithin the Bank’s loan portfolio, the Bank currently has heavy exposure in fourbroad industry categories: commercial construction and development; real estaterenting and leasing; other services (churches); and public administration.  These industries are monitored closely toensure that underwriting practices, policies and loss allowance levels matchthe level of risk posed.  Real estateloans represented 78.7% of total loans at September 30, 2008 compared to 77.9% at December 31, 2007.  Management of the Bank believes the risk ofthis concentration is acceptable given the quality of underwriting and the lowlevel of historical loss experience.  TheBank’s exposure to commercial borrowers in the construction and developmentindustries declined by $2.1 million in the third quarter.  Loans in this industry were $31.0 million at September 30,2008, which represents 10.9% of commercial loans outstanding and whichmanagement believes is quite moderate in comparison to peers.  The Bank’s exposure to the residentialconstruction component in particular is down considerably from peak levelsreached 18 months ago.  The portfolioremains well diversified across several different types of construction anddevelopment activity.  All loans areexpected to be repaid from cash flow or proceeds from the sale of selectedassets of the borrowers.  Collateralrequirements for the loan portfolio are based on credit evaluation of theborrowers.

 

Theanalysis and review of asset quality by the Bank’s credit administrationincludes a formal review that evaluates the adequacy of the allowance forpossible loan and lease losses.  Thisreview is updated monthly and evaluated more completely quarterly inconjunction with loan review reports and evaluations that are discussed inmeetings with loan officers, credit administration and the Bank’s Board ofDirectors.  The allowance for possibleloan and lease losses was $7.4 million, or 1.3% of gross loans and leases, at September 30, 2008, compared to$7.4 million, or 1.5% of gross loans and leases, at December 31,2007.  Net charge-offs through September 30, 2008 wereapproximately $75,000, which results in an annualized net charge-off ratio of0.19%.

 

Aformal process is in place to enhance control over the underwriting of loansand to monitor loan collectability.  Thisprocess includes education and training of personnel about the Bank’s loanpolicies and procedures, credit analysts to support lenders, timelyidentification of loans with adverse characteristics, control of correctiveactions and objective monitoring of loan reviews.  The Special Assets Department of the Bankidentifies and monitors assets that need attention.  At September 30, 2008, this process identified loanstotaling $17.5 million, or 3.1% of the portfolio, that were classified as otherassets especially mentioned, compared to loans totaling $8.2 million, or 1.7%of the portfolio, so classified at 

 

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December 31,2007.  Loans totaling $14.5 million, or2.6% of the portfolio, were classified as substandard at September 30, 2008, compared toloans totaling $7.4 million, or 1.5% of the portfolio, so classified at .  No loans were classified as doubtful at September 30, 2008 and December 31,2007.

 

**Deposits**

 

The Bank does not have anyforeign offices and all deposits are serviced in its 20 domestic offices.  The Bank’s average deposits increased 2.8%during the first nine months of 2008 compared to a decline of 1.0% in the firstnine months of 2007.  The increaseresults from the Bank offering more competitive rates on interest-bearingdeposits.  Average total noninterest-bearingdeposits, which contribute to the Bank’s low cost of deposits, were 17.4% oftotal deposits at September 30, 2008, compared to 17.9% at September 30,2007 and 18.0% at December 31, 2007.

 

**RegulatoryRequirements for Capital**

 

TheCorporation and the Bank are subject to federal regulatory risk-adjustedcapital adequacy standards.  Failure tomeet capital adequacy requirements could result in certain mandatory, andpossibly additional discretionary actions by regulators that could have adirect material adverse effect on the financial condition of the Corporationand the Bank.  The regulations requirethe Corporation and the Bank to meet specific capital adequacy guidelines thatinvolve quantitative measures of assets, liabilities and certain off-balance-sheetitems as calculated under regulatory accounting practices.  The capital classification is also subject toqualitative judgments by the regulators about components, risk weightings andother factors.

 

 Quantitative measures establishedby the Board of Governors of the Federal Reserve System to ensure capitaladequacy require the Corporation and the Bank to maintain minimum amounts andratios of Tier 1 Capital and Total Capital (Tier 1 plus Tier 2 Capital) torisk-weighted assets and of Tier 1 Capital to average total assets (leveragecapital ratio).   Equity capital (net ofcertain adjustments for intangible assets and investments in non-consolidatedsubsidiaries and certain classes of preferred stock) is considered Tier 1Capital.  Tier 2 Capital consists of corecapital plus subordinated debt, some types of preferred stock, and a definedpercentage of the allowance for possible loan and lease****losses.  To be “well-capitalized” under federal bankregulations, a bank holding company must have a Tier 1 Capital ratio of atleast 6%, a Total Capital ratio of at least 10%, and a leverage capital ratioof at least 5%.  As of September 30, 2008, theCorporation’s Tier 1, Total Capital and leverage capital ratios were 16.5%,17.7% and 11.5 %, respectively.  Theratios were 16.9%, 18.2% and 12.2%, respectively, at December 31,2007.  As of September 30, 2008, the Bank’s Tier 1 Capital,Total Capital and leverage capital ratios were 16.5%, 17.4%, and 11.3%,respectively, compared to 16.6%, 17.9%, and 11.9% at December 31, 2007.Management believes, as of September 30, 2008, that the Corporation andthe Bank each met all capital adequacy requirements to which they are subject.

 

**Liquidity and Capital****Resources**

 

 Most of the capital needs of theBank have historically been financed with retained earnings and depositsreceived and the Corporation’s primary source of liquidity is dividendsdeclared by the Bank.  During March 2008,the Bank obtained five advances of $7 million each for an aggregate borrowingof $35 million from the FHLB. Scheduled repayment of the advances willbegin in 2009 and end in 2013.  InSeptember, the Bank obtained two additional advances of $3.1 million each, fora total borrowing for 2008 of $41.2 million. Please refer to Note 4 in the notes to consolidated financial statementsfor details.

 

 The Bank is subject to Tennesseestatutes and regulations that impose restrictions on the amount of dividendsthat may be declared.  Furthermore, anydividend payments are subject to the continuing ability of the Bank to maintainits compliance with minimum federal regulatory capital requirements and toretain its characterization under federal regulations as a “well-capitalized”institution. The Bank declared a $0.355 per share dividend in the second quarterof 2008, which was paid in the third quarter of 2008.

 

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.  TheBank’s Board of Directors has adopted a liquidity policy that outlines specificliquidity target balances.  Compliancewith this policy is 

 

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reviewedquarterly by the Bank’s Asset/Liability Committee and results are reported tothe Bank’s Board of Directors. The Bank’s formal asset and liability managementprocess is used to control interest rate risk and assist management inmaintaining reasonable stability in the gross interest margin as a result ofchanges in the level of interest rates and/or the spread relationships amonginterest rates.  The Bank uses an earningssimulation model to evaluate the impact of different interest rate scenarios onthe gross margin.  Each quarter, the Bank’sAsset/Liability Committee monitors the relationship of rate sensitive earningassets to rate sensitive interest-bearing liabilities (interest ratesensitivity), which is the principal factor in determining the effect thatfluctuating interest rates will 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.

 

**Critical Accounting 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 connection with the application of thoseprinciples, the Bank’s management has made judgments and estimates that, in thecase of the determination of the allowance for loan and lease losses (“ALLL”)and the recognition of deferred income tax assets, have been critical to thedetermination of the Corporation’s financial position, results of operationsand cash flows.  As of September 30,2008, the deferred income tax asset was $6.2 million, which was included withother assets on the balance sheet.

 

*Allowancefor Loan and Lease Losses*

 

The Bank’s management assesses the adequacy of the ALLL prior to theend of each month and prepares a more formal review quarterly to assess therisk in the Bank’s loan portfolio.  Thisassessment includes procedures to estimate the allowance and test the adequacyand appropriateness of the resulting balance. The ALLL represents calculated amounts for specifically identifiedcredit exposure and exposures readily predictable by historical or comparativeexperience.  Even though this calculationconsiders specific credits, the entire allowance is available to absorb anycredit losses.

 

These calculated amounts are determined by assessing loans identifiedas not in compliance with loan agreements. These loans are generally in two different risk groups.  One group is unique loans (commercial loans,including those loans considered impaired). The second group is pools of homogenous loans (generally retail andmortgage loans).  The calculation forunique loans is based primarily on risk rating grades assigned to each of theseloans as a result of the Bank’s loan management and review processes.  Each risk-rating grade is assigned a lossratio, which is determined based on the experience of management, discussionswith banking regulators and the independent loan review process.  The amount allocated for an impaired loan isbased on estimated cash flows discounted at the loan’s original effectiveinterest rate or the underlying collateral value.  Historical data, including actual lossexperience on specific types of homogenous loans, is used to allocate amountsfor loans or groups of loans meeting the specified criteria.  Management has developed procedures thatprovide more detailed historical data by category of retail and consumer creditand performance characteristics that broaden the analysis and improvemonitoring of potential credit risk.

 

Criteriaconsidered and processes utilized in evaluating the adequacy of the ALLL are:

 

·                  Portfolio quality trends;

·                  Changes in the nature andvolume of the portfolio;

·                  Present and prospectiveeconomic and business conditions, locally and nationally;

·                  Management review systemsand board oversight, including external loan review processes;

·                  Changes in credit policy,credit administration, portfolio management and procedures;

·                  Changes in personnel,management and staff; and

·                  Existence and effect of anyconcentrations of credit.

 

In assessing the adequacy of the ALLL, the risk characteristics of theentire loan portfolio are evaluated. This process includes the judgment of the Bank’s management, input fromindependent loan reviews and reviews that may have been conducted by bankregulators as part of their usual examination process.

 

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*DeferredIncome Tax Assets*

 

Deferred income tax assets consist mainly of the taxeffect of excess provisions for loan and lease****lossesover actual losses incurred and deferred compensation.  Management believes that it is more likelythan not that these assets will be realized in future years.

 

**OFF-BALANCE SHEET 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.  These financial instruments includecommitments to extend credit and stand-by letters of credit.  Those instruments involve, to varyingdegrees, elements of credit risk in excess of the amount recognized on thebalance sheet.  The contract or notionalamounts of those instruments reflect the extent of involvement the Bank has inthose financial instruments.  Loancommitments are agreements to lend to a customer as long as there is not aviolation of any condition established in the contract.  Stand-by letters of credit are conditionalcommitments issued by the Bank to guarantee the performance of a customer to athird party.  Those guarantees areprimarily issued to support public and private borrowing arrangements,including commercial paper, bond financing and similar transactions.  The credit risk involved in issuing lettersof credit is essentially the same as that involved in making a loan.

 

Thetotal outstanding loan commitments and stand-by letters of credit in the normalcourse of business at September 30,2008 were $110.9 million and $11.1 million, respectively, compared to$116.9 million and $12.0 million, respectively, at September 30, 2007 and$139.6 million and $17.7 million, respectively at December 31, 2007.

 

AtSeptember 30,2008, the Corporation and the Bank did not have any off-balance sheetarrangements other than commitments to extend credit and stand-by letters ofcredit.

 

**RESULTS OF OPERATIONS**

 

Totalinterest income for the first nine months of 2008 was $32.9 million compared to$32.6 million for the first nine months of 2007, and $10.9 million for thethree months ended September 30, 2008 compared to $11.0 million for thethree months ended September 30, 2007. Interest and fees earned on loans and investments are the components oftotal interest income.  Interest and feesearned on loans were $24.7 million, a decrease of approximately $75,000, or0.3%, during the first nine months of 2008 compared to the first nine months of2007, and $8.2 million for the three months ended September 30, 2008, adecrease of approximately $287,000, or 3.4%, compared to the three months endedSeptember 30, 2007.  Nominalinterest earned on investment securities and other investments was $8.2million, an increase of approximately $417,000, or 5.3%, during the first ninemonths of 2008 compared to the first nine months of 2007, and $2.7 million forthe three months ended September 30, 2008 compared to $2.5 million for thethree months ended September 30, 2007.

 

Total interest expense in the first nine months of 2008 was $9.5million, a decrease of $2.6 million, or 21.2%, compared to the first ninemonths of 2007, and $3.0 million for the three months ended September 30,2008, a decrease of $1.0 million, or 25.6%, compared to the three months ended September 30,2007.  The lower interest rates forcertificates of deposits and public funds during the first nine months of 2008were the primary reason for the lower expense. As a policy, budgeted financial goals are monitored on a monthly basisby the Bank’s Asset/Liability Committee, which reviews the actual dollar changein net interest income for different interest rate movements.  A negative dollar change in net interestincome for a 12-month and 24-month period of less than 10.0% of net interestincome given a 100-200 basis point shift in interest rates is considered anacceptable rate risk position.  The raterisk analysis for the 12-month period beginning October 1, 2008 and endingSeptember 30, 2009 showed a worst-case potential change to net interestincome of a negative 6.6%, reflecting a potential decline in net interestincome of $2.1 million by the end of the period.

 

Net interest income of the Corporation on a fully taxable equivalentbasis is influenced primarily by changes in:

(1)                                  the volume andmix of earning assets and sources of funding;

(2)                                  market rates ofinterest; and

(3)                                  income taxrates.

 

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The impact of some of these factors can be controlled by managementpolicies and actions.  External factorsalso can have a significant impact on changes in net interest income from oneperiod to another.  Some examples of suchfactors are:

 

(1)           the strength ofcredit demands by customers;

(2)           Federal ReserveBoard monetary policy; and

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

 

The net interest margin, on a tax equivalent basis, at September 30, 2008, September 30, 2007 and December,31, 2007 was 4.36%, 4.07% and 4.11%, respectively.

 

The analysis and review of asset quality by Management’s loan reviewfunction and credit administration also includes a formal review that isprepared quarterly to assess the risk in the loan portfolio and to determinethe adequacy of the allowance for loan and lease losses.  An addition of $50,000 was made to the allowanceduring the third quarter of 2008.  Priorto the third quarter, no additions had been made to the allowance for2008.  The review supported management’sassertion that the allowance was adequate at September 30, 2008.

 

Noninterest incomewas $10.2 million, an increase of $1.4 million, or 15.8%, during the first ninemonths of 2008 compared to the first nine months of 2007, and $3.3 million forthe three months ended September 30, 2008 compared to $2.9 million for thethree months ended September 30, 2007. Contributing to this increase for the nine-month period were gains onsales of available-for-sale securities, representing $1.3 million in income.

 

Noninterestexpenses, excluding the provision for possible loan and lease losses, were up$2.1 million, or 9.9%, in the first nine months of 2008 as compared to thefirst nine months of 2007, and $585,000, or 8.0%, higher for the three monthsended September 30, 2008 compared to the three months ended September 30,2007. Salaries andbenefits expense was up $1.3 million, or 11.1%, for the nine months ended September 30,2008 compared to the same period in 2007, and up approximately $222,000, or5.5%, for the three months ended September 30, 2008 compared to the sameperiod in 2007 because of changes in the Bank’s incentive and retirementplans.  Other operating expenses were upapproximately $664,000, or 8.8%, for the nine months ended September 30,2008 compared to the same period in 2007, and up approximately $290,000, or12.29%, for the three months ended September 30, 2008 compared to the sameperiod in 2007 because of increases in advertising expenses and professionalfees.

 

 The Corporation does not have anylong-term debt or other long-term obligations other than the $41.2 millionaggregate advances from the FHLB received by the Bank in March and September 2008.   Scheduled repayment of the advances will begin in 2009and end in 2013.  Please refer to Note 4in the notes to consolidated financial statements for details.

 

TheBank leases certain bank properties. There was not a change during the nine-month period ended September 30, 2008 in the termsof these leases.

 

Netincome for the nine months ended September 30, 2008 was $8.1 million, comparedto $6.2 million for the nine months ended September 30, 2007, and $2.8 million for the threemonths ending September 30, 2008 compared to $2.1 million for the threemonths ending September 30, 2007. An increase in service fees, along with a realized gain onavailable-for-sale securities, contributed to the period-over-periodincreases.  The Corporation earned $0.50per share in the third quarter of 2008 and $0.37 per share in the third quarterof 2007.

 

**Item 3.  Quantitative andQualitative Disclosures About Market Risk.**

 

Duringthe nine months ended September 30,2008, there were no material changes in the quantitative and qualitativedisclosures about market risk presented in the Corporation’s Annual Report on Form 10-Kfor the year ended December 31, 2007.

 

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**Item 4. Controls and Procedures.**

 

(a)           Evaluation of Disclosure Controlsand Procedures.  The Corporation,with the participation of its management, including the Corporation’s ChiefExecutive Officer and Assistant Treasurer (principal financial officer),carried out an evaluation of the effectiveness of the design and operation ofits disclosure controls and procedures (as defined in Rules 13a-15 and15d-15 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”))as of the end of the period covered by this report.  Based upon that evaluation and as of the endof the period covered by this report, the Corporation’s Chief Executive Officerand Assistant Treasurer (principal financial officer) concluded that theCorporation’s disclosure controls and procedures were effective in ensuringthat information required to be disclosed in its reports that the Corporationfiles or submits to the Securities and Exchange Commission under the ExchangeAct is recorded, processed, summarized and reported on a timely basis.

 

(b)           Changes in Internal Control OverFinancial Reporting.  There has beenno change in the Corporation’s internal control over financial reporting thatoccurred during the third quarter of 2008 that has materially affected, or isreasonably likely to materially affect, the Corporation’s internal control overfinancial reporting.

 

**PART II- OTHER INFORMATION**

 

**Item 1A. Risk Factors.**

 

There have been no material changes in the risk factors previouslydisclosed in the Corporation’s Annual Report on Form 10-K for the yearended December 31, 2007.

 

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

 

The following table provides information regarding purchases of theCorporation’s common stock made by the Corporation during the third quarter of2008:

 
| **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** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| July 1,  2008 – July 30, 2008                |       | —                                                   |       | —                                       |       | —                                                                                                                                             |       | —                                                                                                                                                                                              |       |
| August 1,  2008 – August 31, 2008       |       | —                                                   |       | —                                       |       | —                                                                                                                                             |       | —                                                                                                                                                                                              |       |
| September 1,  2008 – September 30, 2008 |       | 19,643                                                   | *          | $                                            | 50.00      |                                                                                                                                               | —     |                                                                                                                                                                                                | —     |   |
| Total                                                  |       | 19,643                                                   |       | $                                            | 50.00      |                                                                                                                                               | —     |                                                                                                                                                                                                | —     |   |

 

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*Purchased through negotiated transactions with several third-partysellers.

 

**Item 6.  Exhibits.**

 
| **EXHIBIT****NUMBER** | ** ** | **DESCRIPTION** |
|-----------------------|------------|-----------------|
|                  |       |            |   |
| 3.1                   |       |            | Charter  (1) |
| 3.2                   |       |            | Articles  of Amendment to Charter (1) |
| 3.3                   |       |            | Amended  and Restated By-laws (2) |
| 31.1                  |       |            | Certification  of the Chief Executive Officer of First Farmers and Merchants Corporation  Pursuant to Rule 13a-14 of the Securities Exchange Act of 1934, as  amended, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 |

 

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| 31.2 |   | Certification of the Assistant Treasurer (principal financial  officer) of First Farmers and Merchants Corporation Pursuant to  Rule 13a-14 of the Securities Exchange Act of 1934, as amended, as  Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 32.1 |   | Certification of the Chief Executive Officer and Assistant Treasurer  (principal financial officer) of First Farmers and Merchants Corporation  Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002             |

 

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(1)  Incorporated by reference to the First Farmers and MerchantsCorporation Amendment No. 1 to the Annual Report on Form 10-K/A forthe year ended December 31, 2003, File Number 000-10972, as filed with theSecurities and Exchange Commission on May 7, 2004.

(2)  Incorporated by reference to the First Farmers and MerchantsCorporation Current Report on Form 8-K, File Number 000-10972, as filed with the Securities and ExchangeCommission on April 23, 2007.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   |                                                                                            | FIRST FARMERS  AND MERCHANTS CORPORATION                                                                                                                                                                                                   |
|--------|-------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                            |                                      (Registrant) |
|   |                                                                                            |                                                                                                                                                                                                                                       |
|   |                                                                                            |                                                                                                                                                                                                                                       |
| Date   |             November 10,  2008 |                                                                                                                                                                                                                                       |                    /s/  T. Randy Stevens |
|   |                                                                                            |                                                                                                                                                                                                                                       | T. Randy Stevens, Chief  Executive Officer |
|   |                                                                                            |
|   |                                                                                            |
| Date   |             November 10,  2008 |                                                                                                                                                                                                                                       |              /s/  Patricia P. Bearden |
|   |                                                                                            |                                                                                                                                                                                                                                       | Patricia P. Bearden, Assistant  Treasurer (principal financial officer and principal accounting officer) |
|        |                                                                                                 |                                                                                                                                                                                                                                            |  |  |

 

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

 

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(1)  Incorporated by reference to the First Farmers and MerchantsCorporation Amendment No. 1 to the Annual Report on Form 10-K/A forthe year ended December 31, 2003, File Number 000-10972, as filed with theSecurities and Exchange Commission on May 7, 2004.

(2)  Incorporated by reference to the First Farmers and MerchantsCorporation Current Report on Form 8-K, File Number 000-10972, as filedwith the Securities and Exchange Commission on April 23, 2007.

 

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