**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**(Mark one)**

 

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

 

**For thequarterly period ended June 30, 2009**

 

**or**

 

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

 

**For thetransition period from                  to                  **

 

**CommissionFile Numbers: 000-10972**

 

**FirstFarmers and Merchants Corporation**

(Exact name ofregistrant as specified in its charter)

 

| **Tennessee**                                                   | ** ** | **62-1148660**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or organization) |       | (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 forthe past 90 days.  x Yes  o No

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T during the preceding 12months (or for such shorter period that the registrant was required to submitand post such files).  o Yes  o 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 o                     |   | Accelerated  filer x         |
|------------------------------------------------|--------|------------------------------|
|                                           |   |                         |
| Non-accelerated  filer o                       |   | Smaller  reporting company o |
| (Do not check if  a smaller reporting company) |   |                         |

 

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

 

As of August 7,2009, the registrant had outstanding 5,530,000 shares of common stock.

 

 

 

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**PART I - FINANCIAL INFORMATIO**N

 

**Item 1. Financial Statements.**

 

The following unauditedconsolidated financial statements of the Registrant and its subsidiaries areincluded in this Report:

 

Consolidated balancesheets – June 30, 2009 and December 31, 2008.

 

Consolidated statementsof income - For the three months and six months ended June 30, 2009 and June 30,2008.

 

Consolidated statementsof cash flows - For the six months ended June 30, 2009 and June 30, 2008.

 

Selected notes toconsolidated financial statements.

 

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**FIRSTFARMERS AND MERCHANTS CORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

 
| **(Dollars  in Thousands, Except Per Share Data)**                                                                                                                                                   | ** ** | **June 30,  2009  (Unaudited)** | ** **  | **December 31,  2008  (1)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|-------------|----------------------------------|------------|
| **ASSETS**                                                                                                                                                                                           |       |                                 |        |                             |       |
| Cash and due from banks                                                                                                                                                                              | ** ** | **$**                                | **43,384**  |                             | $          | 22,656 |   |
| Interest-bearing due from banks                                                                                                                                                                      | ** ** | **2,928**                            |        | 4,680                            |       |
| Federal funds sold                                                                                                                                                                                   | ** ** | **300**                              |        | 4,200                            |       |
| Total cash and cash  equivalents                                                                                                                                                                     | ** ** | **46,612**                           |        | 31,536                           |       |
| Securities                                                                                                                                                                                           |       |                                 |        |                             |       |
| Available-for-sale  (amortized cost $190,200 and $171,891, respectively)                                                                                                                             |       | **187,980**                          |        | 174,493                          |       |
| Held-to-maturity  (fair market value $51,818 and $59,558, respectively)                                                                                                                              |       | **51,593**                           |        | 59,427                           |       |
| Total Securities                                                                                                                                                                                     | ** ** | **239,573**                          |        | 233,920                          |       |
| Loans, net of deferred fees                                                                                                                                                                          | ** ** | **598,527**                          |        | 595,519                          |       |
| Allowance for loan losses                                                                                                                                                                            | ** ** | **(8,210**                           | **)**       | (8,625                           | )          |
| Net loans                                                                                                                                                                                            | ** ** | **590,317**                          |        | 586,894                          |       |
| Bank  premises and equipment, at cost less allowance for depreciation                                                                                                                                |       | **20,597**                           |        | 17,669                           |       |
| Core deposit and other intangibles                                                                                                                                                                   | ** ** | **9,149**                            |        | 9,186                            |       |
| Other assets                                                                                                                                                                                         | ** ** | **37,053**                           |        | 31,932                           |       |
| TOTAL ASSETS                                                                                                                                                                                         | ** ** | **$**                                | **943,301** |                             | $          | 911,137 |   |
| **LIABILITIES**                                                                                                                                                                                      |       |                                 |        |                             |       |
| Deposits                                                                                                                                                                                             |       |                                 |        |                             |       |
| Noninterest-bearing                                                                                                                                                                                  | ** ** | **$**                                | **145,692** |                             | $          | 118,111 |   |
| Interest-bearing  (including certificates of deposits over $100: 2009 - $149,490; 2008 -  $107,607)                                                                                                  |       | **640,678**                          |        | 626,740                          |       |
| Total deposits                                                                                                                                                                                       | ** ** | **786,370**                          |        | 744,851                          |       |
| Federal  funds purchased and securities sold under agreements to repurchase                                                                                                                          |       | **2,431**                            |        | 2,645                            |       |
| Dividends payable                                                                                                                                                                                    | ** ** | **2,018**                            |        | 2,009                            |       |
| Short-term borrowings                                                                                                                                                                                | ** ** | **600**                              |        | 294                              |       |
| Accounts payable and accrued liabilities                                                                                                                                                             | ** ** | **13,699**                           |        | 12,890                           |       |
| Federal Home Loan Bank Advances                                                                                                                                                                      | ** ** | **34,177**                           |        | 41,177                           |       |
| TOTAL LIABILITIES                                                                                                                                                                                    | ** ** | **839,295**                          |        | 803,866                          |       |
| **SHAREHOLDERS’****EQUITY**                                                                                                                                                                     |       |                                 |        |                             |       |
| Common  stock – $10 par value per share, 8,000,000 shares authorized; 5,530,000 and  5,580,000 shares issued and outstanding as of June 30, 2009 and December 31,  2008, respectively |       | **55,300**                           |        | 55,800                           |       |
| Retained earnings                                                                                                                                                                                    | ** ** | **49,976**                           |        | 49,776                           |       |
| Accumulated other comprehensive income (loss)                                                                                                                                                        | ** ** | **(1,365**                           | **)**       | 1,600                            |       |
| TOTAL  FIRST FARMERS CORPORATION SHAREHOLDERS’ EQUITY                                                                                                                                           |       | **103,911**                          |        | 107,176                          |       |
| Non-controlling interest                                                                                                                                                                             | ** ** | **95**                               |        | 95                               |       |
| TOTAL SHAREHOLDERS’ EQUITY                                                                                                                                                                      | ** ** | **104,006**                          |        | 107,271                          |       |
| TOTAL  LIABILITIES AND SHAREHOLDERS’ EQUITY                                                                                                                                                     |       | **$**                                | **943,301** |                             | $          | 911,137 |   |

 

----

(1) Derived from auditedfinancial statements.

 

The accompanying notes are anintegral part of consolidated financial statements.

 

3

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**FIRSTFARMERS AND MERCHANTS CORPORATION AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF INCOME**

 
| **(Dollars  in Thousands, Except Per Share Data)**             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Month Ended  June 30,** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| **(Unaudited)**                                                | ** ** | **2009**                              | ** ** | **2008**                           | ** ** | **2009** | ** ** | **2008** | ** ** |
|                                                           |       |                                  |       |                               |       |   |   |   |   |
| **INTEREST AND DIVIDEND INCOME**                               |       |                                  |       |                               |       |   |   |   |   |
| Interest and fees on loans                                     | ** ** | **$**                                 | **7,910**  |                               | $          | 8,141 | ** ** | **$** | **15,777** |   | $ | 16,477 |   |
| Income on investment securities                                |       |                                  |       |                               |       |   |   |   |   |
| Taxable interest                                               | ** ** | **1,119**                             |       | 1,775                              | ** ** | **2,445** |   | 3,301 |   |
| Exempt from federal income tax                                 | ** ** | **946**                               |       | 939                                | ** ** | **1,920** |   | 1,958 |   |
| Dividends                                                      | ** ** | **46**                                |       | 53                                 | ** ** | **106** |   | 106 |   |
|                                                           | ** ** | **2,111**                             |       | 2,767                              | ** ** | **4,471** |   | 5,365 |   |
| Other interest income                                          | ** ** | **27**                                |       | 77                                 | ** ** | **44** |   | 128 |   |
| TOTAL INTEREST INCOME                                          | ** ** | **10,048**                            |       | 10,985                             | ** ** | **20,292** |   | 21,970 |   |
|                                                           |       |                                  |       |                               |       |   |   |   |   |
| **INTEREST EXPENSE**                                           |       |                                  |       |                               |       |   |   |   |   |
| Interest on deposits                                           | ** ** | **2,083**                             |       | 2,929                              | ** ** | **4,327** |   | 6,265 |   |
| Interest on other borrowings                                   | ** ** | **291**                               |       | 193                                | ** ** | **603** |   | 244 |   |
| TOTAL INTEREST EXPENSE                                         | ** ** | **2,374**                             |       | 3,122                              | ** ** | **4,930** |   | 6,509 |   |
| NET INTEREST INCOME                                            | ** ** | **7,674**                             |       | 7,863                              | ** ** | **15,362** |   | 15,461 |   |
| PROVISION FOR POSSIBLE LOAN AND LEASE LOSSES                   | ** ** | **770**                               |       | —                             | ** ** | **1,425** |   | — |   |
| NET INTEREST INCOME AFTER PROVISION FOR LOAN AND  LEASE LOSSES | ** ** | **6,904**                             |       | 7,863                              | ** ** | **13,937** |   | 15,461 |   |
|                                                           |       |                                  |       |                               |       |   |   |   |   |
| **NONINTEREST INCOME**                                         |       |                                  |       |                               |       |   |   |   |   |
| Trust department income                                        | ** ** | **436**                               |       | 609                                | ** ** | **994** |   | 1,256 |   |
| Service fees on deposit accounts                               | ** ** | **1,833**                             |       | 1,964                              | ** ** | **3,555** |   | 3,836 |   |
| Other fees and commissions                                     | ** ** | **156**                               |       | 135                                | ** ** | **240** |   | 237 |   |
| Other operating income                                         | ** ** | **268**                               |       | 290                                | ** ** | **367** |   | 413 |   |
| Securities gains                                               | ** ** | **527**                               |       | 120                                | ** ** | **2,482** |   | 1,128 |   |
| TOTAL NONINTEREST INCOME                                       | ** ** | **3,220**                             |       | 3,118                              | ** ** | **7,638** |   | 6,870 |   |
|                                                           |       |                                  |       |                               |       |   |   |   |   |
| **NONINTEREST EXPENSE**                                        |       |                                  |       |                               |       |   |   |   |   |
| Salaries and employee benefits                                 | ** ** | **4,143**                             |       | 4,296                              | ** ** | **8,313** |   | 8,579 |   |
| Net occupancy expense                                          | ** ** | **628**                               |       | 638                                | ** ** | **1,269** |   | 1,240 |   |
| Furniture and equipment expense                                | ** ** | **220**                               |       | 275                                | ** ** | **548** |   | 502 |   |
| Other operating expenses                                       | ** ** | **3,179**                             |       | 2,798                              | ** ** | **6,086** |   | 5,500 |   |
| TOTAL NONINTEREST EXPENSES                                     | ** ** | **8,170**                             |       | 8,007                              | ** ** | **16,216** |   | 15,821 |   |
| INCOME BEFORE PROVISION FOR INCOME TAXES                       | ** ** | **1,954**                             |       | 2,974                              | ** ** | **5,359** |   | 6,510 |   |
| PROVISION FOR INCOME TAXES                                     | ** ** | **229**                               |       | 458                                | ** ** | **926** |   | 1,246 |   |
| NET INCOME                                                     | ** ** | **$**                                 | **1,725**  |                               | $          | 2,516 | ** ** | **$** | **4,433** |   | $ | 5,264 |   |
| ** **                                                     | ** ** | ** **                            |       |                               | ** ** | ** ** |   |   |   |
| **BASIC EARNINGS PER SHARE**                                   | ** ** | ** **                            |       |                               | ** ** | ** ** |   |   |   |
| Weighted Average Shares  Outstanding                           |       | **5,547,088**                         |       | 5,648,732                          |       | **5,560,856** |   | 5,662,428 |   |
| Basic Earnings Per Share                                       | ** ** | **$**                                 | **0.31**   |                               | $          | 0.45 | ** ** | **$** | **0.80** |   | $ | 0.93 |   |

 

The accompanying notes are anintegral part of the consolidated financial statements.

 

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**FIRSTFARMERS AND MERCHANTS CORPORATION AND SUBSIDIARY**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| **(Dollars  in Thousands)**                                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| **(Unaudited)**                                                                   | ** ** | **2009**                            | ** ** | **2008** | ** ** |
| **OPERATING ACTIVITIES**                                                          |       |                                |       |   |   |
| Net income                                                                        | ** ** | **$**                               | **4,433**  |   | $ | 5,264 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities |       |                                |       |   |   |
| (Deficiency)  excess of provision for possible loan losses over net charge-offs   |       | **(415**                            | **)**      | 311 |   |
| Provision  for depreciation and amortization of premises and equipment            |       | **571**                             |       | 526 |   |
| Securities gains                                                                  | ** ** | **(2,482**                          | **)**      | (1,128 | ) |
| Gain from disposition of fixed assets                                             | ** ** | **129**                             | ** ** | **—** | ** ** |
| (Gain) loss from disposition of other real estate                                 | ** ** | **(6**                              | **)**      | 283 |   |
| Amortization of deposit base intangibles                                          | ** ** | **37**                              |       | 95 |   |
| Amortization  of investment security premiums, net of accretion of discounts      |       | **511**                             |       | 180 |   |
| Increase in cash surrender value of life insurance  contracts                     | ** ** | **(15**                             | **)**      | (776 | ) |
| Decrease (increase) in                                                            |       |                                |       |   |   |
| Deferred income taxes                                                             | ** ** | **457**                             |       | (266 | ) |
| Interest receivable                                                               | ** ** | **(108**                            | **)**      | 444 |   |
| Other assets                                                                      | ** ** | **(3,623**                          | **)**      | (382 | ) |
| (Decrease) increase in                                                            |       |                                |       |   |   |
| Interest payable                                                                  | ** ** | **(397**                            | **)**      | (362 | ) |
| Other liabilities                                                                 | ** ** | **1,207**                           |       | 2,308 |   |
| Total adjustments                                                                 | ** ** | **(4,134**                          | **)**      | 1,233 |   |
| Net cash provided by operating activities                                         | ** ** | **299**                             |       | 6,497 |   |
| **INVESTING ACTIVITIES**                                                          |       |                                |       |   |   |
| Proceeds  from maturities, calls, and sales of available-for-sale securities      |       | **148,217**                         |       | 85,880 |   |
| Proceeds from maturities and calls of  held-to-maturity securities                | ** ** | **7,834**                           |       | 7,372 |   |
| Purchases of investment securities                                                |       |                                |       |   |   |
| Available-for-sale                                                                | ** ** | **(164,554**                        | **)**      | (90,889 | ) |
| Held-to-maturity                                                                  | ** ** | **—**                          |       | — |   |
| Net increase in loans                                                             | ** ** | **(3,008**                          | **)**      | (34,382 | ) |
| Proceeds from sale of other real estate                                           | ** ** | **41**                              |       | 385 |   |
| Proceeds from sale of fixed assets                                                | ** ** | **—**                          |       | — |   |
| Purchase of life insurance premium                                                | ** ** | **(235**                            | **)**      | (696 | ) |
| Purchases of premises and equipment                                               | ** ** | **(3,628**                          | **)**      | (989 | ) |
| Net cash used in investing activities                                             | ** ** | **(15,333**                         | **)**      | (33,319 | ) |
| **FINANCING ACTIVITIES**                                                          |       |                                |       |   |   |
| Net  increase in noninterest-bearing and interest-bearing deposits                |       | **41,520**                          |       | 22,185 |   |
| Net increase in short term borrowings                                             | ** ** | **90**                              |       | 131 |   |
| (Payments) proceeds from FHLB borrowings                                          | ** ** | **(7,000**                          | **)**      | 35,000 |   |
| Repurchase of common stock                                                        | ** ** | **(2,500**                          | **)**      | (2,768 | ) |
| Cash dividends                                                                    | ** ** | **(2,000**                          | **)**      | (1,991 | ) |
| Net cash used in financing activities                                             | ** ** | **30,110**                          |       | 52,557 |   |
| Increase in cash and cash equivalents                                             | ** ** | **15,076**                          |       | 25,735 |   |
| Cash and cash equivalents at beginning of period                                  | ** ** | **31,536**                          |       | 35,873 |   |
| Cash and cash equivalents at end of period                                        | ** ** | **$**                               | **46,612** |   | $ | 61,608 |   |

 

The accompanying notes are anintegral part of the consolidated financial statements.

 

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**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

 

**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 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 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, 2008. Certainreclassifications have been made to prior year amounts to maintain consistencywith the current year in accordance with Financial Accounting Standards Board (“FASB”)Statement No. 160, “Noncontrolling Interest in Consolidated FinancialStatements, an amendment to ARB Statement No. 51” (“SFAS 160”). This hasresulted in no impact on net income and an increase of $95,000 totalshareholders’ equity.

 

**NOTE 2 –STOCK REPURCHASE**

 

Duringthe second quarter of 2009, the Corporation repurchased, through negotiatedtransactions with third-party sellers, 25,000 shares of the Corporation’scommon stock at a price of $50 per share for an aggregate purchase price of$1.25 million.

 

**NOTE 3 – FAIR VALUEMEASUREMENT**

 

Effective January 1, 2008, the Corporation adopted the provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 157, “Fair Value Measurements”**(“SFAS 157”), for financial assets andfinancial liabilities.  FASB StaffPosition (“FSP”) No. SFAS 157-2, “Effective Date of FASB Statement No. 157”,allowed the Corporation to delay application of SFAS 157 for non-financialassets and non-financial liabilities until January 1, 2009; however, theCorporation elected to apply SFAS 157 to non-financial assets and non-financialliabilities effective January 1, 2008. SFAS 157 defines fair value,establishes a framework for measuring fair value in generally acceptedaccounting principles and expands disclosures about fair valuemeasurements.  The application of SFAS157 in situations where the market for a financial asset is not active wasclarified by the issuance of FSP No. SFAS 157-3, “Determining the FairValue of a Financial Asset When the Market for That Asset Is Not Active” (“SFAS157-3”)*,* in October 2008.SFAS 157-3 became effective immediately and did not significantly affect themethods by which the Corporation determines the fair values of its financialassets.

 

SFAS 157 defines fair value as the price that wouldbe received to sell an asset or paid to transfer a liability in an orderlytransaction between market participants. A fair value measurement assumes that the transaction to sell the assetor transfer the liability occurs in the principal market for the asset orliability or, in the absence of a principal market, the most advantageousmarket for the asset or liability.  Theprice in the principal (or most advantageous) market used to measure the fairvalue of the asset or liability is not adjusted for transaction costs.  An orderly transaction is a transaction that assumes exposure to themarket for a period prior to the measurement date to allow for marketingactivities that are usual and customary for transactions involving such assetsand liabilities; it is not a forced transaction. Market participants are buyersand sellers in the principal market that are (i) independent, (ii) knowledgeable,(iii) able to transact and (iv) willing to transact.

 

SFAS 157 requires the use of valuation techniques that are consistent with themarket approach, the income approach and/or the cost approach.  The market approach uses prices and otherrelevant information generated by market transactions involving identical orcomparable assets and liabilities. The income approach uses valuationtechniques to convert future amounts, such as cash flows or earnings, to asingle present amount on a discounted basis. The cost approach is based on the amount that currently would berequired to replace the service capacity of an asset (i.e., replacement cost).Valuation techniques should be consistently applied.  Inputs to valuation techniques refer to theassumptions that market participants use in pricing the asset or liability.  Inputs may be observable, meaning those thatreflect the 

 

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assumptions market participants would use inpricing the asset or liability, developed based on market data obtained fromindependent sources. Inputs may also be unobservable, meaning those that reflectthe reporting entity’s own assumptions about the assumptions marketparticipants could use in pricing the asset or liability, developed based onthe best information available in the circumstances. In that regard, SFAS 157establishes a fair value hierarchy for valuation inputs that gives the highestpriority to quoted prices in active markets for identical assets or liabilitiesand the lowest priority to unobservable inputs. Thefair value hierarchy is as follows:

 

·                  *Level 1Inputs*- Unadjusted quoted prices in active markets for identical assets orliabilities that the reporting entity has the ability to access at themeasurement date.

 

·                  *Level2 Inputs* - Inputs otherthan quoted prices included in Level 1 that are observable for the asset orliability, either directly or indirectly. These might include quoted prices forsimilar assets or liabilities in active markets, quoted prices for identical orsimilar assets or liabilities in markets that are not active, inputs other thanquoted prices that are observable for the asset or liability (such as interestrates, volatilities, prepayment speeds, credit risks, etc.) or inputs that arederived principally from or corroborated by market data by correlation or othermeans.

 

·                  *Level3 Inputs* - Unobservableinputs for determining the fair values of assets or liabilities that reflect anentity’s own assumptions about the assumptions that market participants woulduse in pricing the assets or liabilities.

 

Adescription of the valuation methodologies used for instruments measured atfair value as well as the general classification of such instruments pursuantto the valuation hierarchy is set forth below. These valuation methodologies were applied to all of the financialassets and financial liabilities of the Corporation and its sole wholly-ownedsubsidiary, First Farmers and Merchants Bank (the “Bank”), carried at fairvalue effective June 30, 2009.  Ifsuch quoted market prices are not available, fair value is based on internallydeveloped models that primarily use, as inputs, observable market-basedparameters. Valuation adjustments may be made to ensure that financialinstruments are recorded at fair value. These adjustments may include amountsto reflect counterparty credit quality and the Corporation’s creditworthinessamong other things, as well as unobservable parameters.  Any such valuation adjustments are appliedconsistently over time.  The Corporation’svaluation methodologies may produce a fair value calculation that may not beindicative of net realizable value or reflective of future fair values.  While management believes the valuationmethodologies are appropriate and consistent with other market participants,the use of different methodologies or assumptions to determine the fair valueof certain financial instruments could result in a different estimate of fairvalue at the reporting date. Furthermore, the reported fair value amounts have not beencomprehensively revalued since the presentation dates and, therefore, estimatesof fair value after the balance sheet date may differ significantly from theamounts presented herein.

 

Financialassets and financial liabilities measured at fair value on a recurring basisinclude the following:

 

*Securities available for sale***—** Securities classified asavailable for sale are reported at fair value utilizing Level 2 inputs.  For these securities, the Corporation obtainsfair value measurements from an independent pricing service.  The fair value measurements considerobservable data that may include dealer quotes, market spreads, cash flows, theU.S. Treasury yield curve, live trading levels, trade execution data, marketconsensus prepayment speeds, credit information and the bond’s terms andconditions, among other things.

 

*Otherassets* — Includedin other assets are certain assets carried at fair value, including the cashvalue of Bank-owned life insurance policies. The carrying amount of these assets is based on information receivedfrom the insurance carriers indicating the financial performance of thepolicies and the amount the Bank would receive should the policies besurrendered.  The Bank reflects theseinvestments within Level 2 of the valuation hierarchy.

 

*Securitiessold under repurchase agreements, federal funds purchased and other borrowings* — At June 30, 2009, all of the Bank’ssecurities sold under repurchase agreements, federal funds purchased and otherborrowings (e.g., overnight borrowings from the Federal Home Loan Bank ofCincinnati (the “FHLB”)) were settled on a short-term basis, usuallydaily.  As a result, the fair value ofthe instruments approximates their carrying amount and such liabilities areclassified as Level 2 within the valuation hierarchy.

 

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* *

*Otherliabilities* — TheBank has certain liabilities carried at fair value.  These include future obligations pursuant toa supplemental retirement plan and proceeds of split-dollar life insurancepolicies.  For these obligations, theBank discounts the anticipated future cash flows using current interestrates.  The liabilities are classified asLevel 2 within the valuation hierarchy.

 

Thefollowing table summarizes financial assets and liabilities measured at fairvalue on a recurring basis as of June 30, 2009, segregated by the level ofthe valuation inputs within the fair value hierarchy utilized to measure fairvalue:

 

**Assets and liabilities measured atfair value on a recurring basis as of June 30, 2009**

 
| ** **                                  | ** ** | **Level 1** | ** ** | **Level 2** | ** **  | **Level 3** | ** ** | **Total**    | ** ** |
|---------------------------------------------|------------|-------------|------------|-------------|-------------|-------------|------------|--------------|------------|
| Federal funds sold                          |       | $           | 300        |        | $           | —      |       | $            | —     |   | $ | 300 |   |
| Available-for-sale securities               |       | —      |       | 187,980     |        | —      |       | 187,980      |       |
| Other assets                                |       | —      |       | 20,397      |        | —      |       | 20,397       |       |
| **Total assets at fair value**              |       | $           | 300        |        | $           | 208,377     |       | $            | —     |   | $ | 208,677 |   |
| Securities sold under repurchase agreements |       | —      |       | $           |  2,431 |        | $          |  — |       | $ |  2,431 |   |
| Other liabilities                           |       | —      |       | 5,079       |        | —      |       | 5,079        |       |
| **Total liabilities at fair value**         |       | $           | —     |        | $           | 7,510       |       | $            | —     |   | $ | 7,510 |   |

 

Certainfinancial assets and liabilities are measured at fair value on a nonrecurringbasis. These instruments are not measured at fair value on an ongoing basis butare subject to fair value adjustments in certain circumstances (for example,when there is evidence of impairment). The only financial asset or liabilitymeasured at fair value on a non-recurring basis for the second quarter of 2009was impaired loans.

 

*Impaired loans —*Certain impaired loans arereported at the fair value of the underlying collateral if repayment isexpected solely from the collateral. Collateral values are estimated using Level 2 inputs based on observablemarket data or Level 3 inputs based on customized discounting criteria.  During the second quarter of 2009, certainimpaired loans were re-measured and reported at fair value through a specificvaluation allowance allocation of the allowance for possible loan losses basedon the fair value of the underlying collateral. Impaired loans with a carrying value of $15.7 million were reduced byspecific valuation allowance allocations totaling $1.1 million to a totalreported fair value of $14.6 million based on collateral valuations utilizingLevel 3 valuation inputs.

 

EffectiveJanuary 1, 2008, the Corporation adopted the provisions of SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities -Including an amendment of FASB Statement No. 115” (“SFAS 159”). SFAS 159permits the Corporation to choose to measure eligible items at fair value atspecified election dates.  Unrealizedgains and losses on items for which the fair value measurement option has beenelected are reported as earnings at each subsequent reporting date. The fairvalue option: (i) may be applied instrument by instrument, with certainexceptions; therefore, the Corporation may record identical financial assetsand liabilities at fair value or by another measurement basis permitted undergenerally accepted accounting principles; (ii) is irrevocable (unless anew election date occurs); and (iii) is applied only to entire instrumentsand not to portions of instruments. Adoption of SFAS 159 on January 1, 2008 did not have a significant impacton the Corporation’s consolidated financial statements.

 

SFASNo. 107, “Disclosures about Fair Value of Financial Instruments,” asamended “SFAS 107”, requires disclosure of the fair value of financial assetsand financial liabilities, including those financial assets and financialliabilities that are not measured and reported at fair value on a recurringbasis or non-recurring basis.  A detaileddescription of the valuation methodologies used in estimating the fair value offinancial instruments is set forth in Note 12 to the consolidated financialstatements incorporated by reference into the Corporation’s Annual Report on Form 10-Kfor the year ended December 31, 2008.

 

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Theestimated fair values of financial instruments were as follows:

 
| ** **                                                                  | ** ** | **June 30,  2009** | ** ** | **December 31, 2008** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                                  | ** ** | **Carrying  Amount**    | ** ** | **Fair  Value**            | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| Financial assets                                                            | ** ** | ** **              | ** ** | ** **                 |       |   |   |   |   |
| Cash and due from banks                                                     | ** ** | **$**                   | **43,384** | ** **                 | **$**      | **43,384** |   | $ | 22,656 |   | $ | 22,656 |   |
| Interest-bearing deposits in banks                                          | ** ** | **2,928**               | ** ** | **2,928**                  |       | 4,680 |   | 4,680 |   |
| Federal funds sold                                                          | ** ** | **300**                 | ** ** | **300**                    |       | 4,200 |   | 4,200 |   |
| Securities available-for-sale                                               | ** ** | **187,980**             | ** ** | **187,980**                |       | 174,493 |   | 174,493 |   |
| Securities held-to-maturity                                                 | ** ** | **51,593**              | ** ** | **51,818**                 |       | 59,427 |   | 59,558 |   |
| Loans, net                                                                  | ** ** | **590,317**             | ** ** | **590,220**                |       | 586,894 |   | 591,471 |   |
| Accrued interest receivable                                                 | ** ** | **4,439**               | ** ** | **4,439**                  |       | 4,331 |   | 4,331 |   |
| Financial liabilities                                                       | ** ** | ** **              | ** ** | ** **                 |       |   |   |   |   |
| Deposits                                                                    | ** ** | **786,370**             | ** ** | **787,827**                |       | 744,851 |   | 746,308 |   |
| Federal  funds purchased and securities sold under agreements to repurchase | ** ** | **2,431**               | ** ** | **2,431**                  |       | 2,645 |   | 2,645 |   |
| Other short term liabilities                                                | ** ** | **600**                 | ** ** | **600**                    |       | 294 |   | 294 |   |
| Accrued interest payable                                                    | ** ** | **1,297**               | ** ** | **1,297**                  |       | 1,693 |   | 1,693 |   |
| Off-balance sheet credit related instruments:                               | ** ** | ** **              | ** ** | ** **                 |       |   |   |   |   |
| Commitments to extend credit                                                | ** ** | ** **              |       | **108**                    |       |   |   | 108 |   |
|                                                                             |            |                         |            |                            |            |  |  |  |  |  |  |  |  |

 

**NOTE 4****–****FEDERAL HOME LOAN BANK CREDITLINE**

 

TheBank has a Blanket Agreement for Advances and Security Agreement (the “BlanketAgreement”) with the FHLB dated March 31, 2008.  Advances made to the Bank under the BlanketAgreement are collateralized by FHLB stock and unidentified qualifyingresidential mortgage loans totaling 150% of the outstanding amountborrowed.  The Bankmade a principal payment of $7.0 million to the FHLB on March 31, 2009.

 

Scheduledannual principal maturities of borrowings under this credit line as of June 30,2009, are as follows:

 

| 2010  |   | 10,077,052 |       |
|-------|--------|------------|------------|
| 2011  |   | 7,000,000  |       |
| 2012  |   | 7,000,000  |       |
| 2013  |   | 10,100,000 |       |
| Total |   | $          | 34,177,052 |   |
|       |        |            |            |  |

 

Stockheld in the FHLB totaling $3.0 million at June 30, 2009 is carried atcost.  The stock is restricted and canonly be sold back to the FHLB at par.

 

The Bankalso has a Cash Management Advance Line of Credit Agreement (the “CMA”) dated March 31,2009 with the FHLB.  The CMA is acomponent of the Blanket Agreement.  Thepurpose of the CMA is to assist with short-term liquidity management.  Under the terms of the CMA, the Bank mayborrow a maximum of $40.0 million, selecting a variable rate of interest for upto 90 days or a fixed rate for a maximum of 30 days.  There were no borrowings outstanding underthe CMA as of June 30, 2009.

 

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**NOTE 5****–****RECENT ACCOUNTING PRONOUNCEMENTS**

 

In December 2007, the FASB replaced SFAS No. 141,**“Business Combinations” (“SFAS 141”),with SFAS No. 141R (“SFAS 141R”). SFAS 141R applies to all transactions and other events in which oneentity obtains control over one or more other businesses. SFAS 141Rrequires an acquirer, upon obtaining control of another entity, to recognizethe assets, liabilities and any non-controlling interest in the acquiree atfair value as of the acquisition date. ** **Contingent consideration isrequired to be recognized and measured at fair value on the date of acquisitionrather than at a later date when the amount of that consideration may bedeterminable beyond a reasonable doubt.**** This fair value approach replaces thecost-allocation process required under SFAS 141 whereby the cost of anacquisition was allocated to the individual assets acquired and liabilitiesassumed based on their estimated fair value. SFAS 141R requires acquirersto expense acquisition-related costs as incurred rather than allocating suchcosts to the assets acquired and liabilities assumed, as was previously thecase under SFAS 141. Under SFAS 141R, the requirements of SFAS No. 146,“Accounting for Costs Associated with Exit or Disposal Activities,” would haveto be met in order to accrue for a restructuring plan in purchase accounting.Pre-acquisition contingencies are to be recognized at fair value except when anon-contractual contingency is not likely to materialize, in which case nothingshould be recognized in purchase accounting. Instead, that contingency would be subject to the probable and estimablerecognition criteria of SFAS No. 5, “Accounting for Contingencies.”SFAS 141R is applicable to the Corporation’s accounting for businesscombinations closing on or after January 1, 2009.

 

In December 2008, the FASB issued SFAS No. 132(R)-1,“Employers’ Disclosures about Postretirement Benefit Plan Assets”**(“SFAS 132(R)-1”).  SFAS132(R)-1 provides guidance related to an employer’s disclosures aboutplan assets of defined benefit pension or other post-retirement benefit plans.Under SFAS 132(R)-1,disclosures should provide users of financial statements with an understandingof how investment allocation decisions are made, the factors that are pertinentto an understanding of investment policies and strategies, the major categoriesof plan assets, the inputs and valuation techniques used to measure the fairvalue of plan assets, the effect of fair value measurements using significant unobservableinputs on changes in plan assets for the period and significant concentrationsof risk within plan assets. The disclosures required by SFAS 132(R)-1 will be included in the Corporation’s financialstatements beginning with the financial statements for the year ended December 31,2009.

 

In April 2009, the FASB issued SFAS No. 157-4,“Determining Fair Value When the Volume and Level of Activity for the Asset orLiability Have Significantly Decreased and Identifying Transactions That AreNot Orderly” (“SFAS 157-4”).  SFAS 157-4affirms that the objective of fair value when the market for an asset is notactive is the price that would be received to sell the asset in an orderlytransaction, and clarifies and includes additional factors for determiningwhether there has been a significant decrease in market activity for an assetwhen the market for that asset is not active. SFAS 157-4 requires anentity to base its conclusion about whether a transaction was not orderly onthe weight of the evidence. SFAS 157-4 also amended SFAS 157 to expandcertain disclosure requirements. The Corporation adopted the provisions ofSFAS 157-4 during the second quarter of 2009. Adoption of SFAS 157-4did not have a significant impact on the Corporation’s financial statements.

 

InFebruary 2008, the FASB issued SFAS No. 160.  SFAS 160 amends Accounting ResearchBulletin No. 51, “Consolidated Financial Statements,” to establishaccounting and reporting standards for the non-controlling interest in a subsidiaryand for the deconsolidation of a subsidiary. SFAS 160 clarifies that anon-controlling interest in a subsidiary, which is sometimes referred to asminority interest, is an ownership interest in the consolidated entity thatshould be reported as a component of equity in the consolidated financialstatements. Among other requirements, SFAS 160 requires consolidated netincome to be reported at amounts that include the amounts attributable to boththe parent and the non-controlling interest. It also requires disclosure, on theface of the consolidated income statement, of the amounts of consolidated netincome attributable to the parent and to the non-controlling interest. Adoptionof SFAS 160 did not have a significant impact on the Corporation’sfinancial statements.

 

InMay 2009, the FASB issued SFAS No. 165, “Subsequent Events” (“SFAS165”).  SFAS 165 establishes generalstandards of accounting for and disclosure of events that occur after thebalance sheet date but before financial statements are issued or available to beissued. SFAS 165 defines (i) the period after the balance sheet dateduring which a reporting entity’s management should evaluate events ortransactions that may occur for potential recognition or disclosure in thefinancial statements, (ii) the circumstances under which an entity shouldrecognize events or transactions occurring after 

 

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thebalance sheet date in its financial statements, and (iii) the disclosuresan entity should make about events or transactions that occurred after thebalance sheet date. SFAS 165 became effective for the Corporation’sfinancial statements for periods ending after June 15, 2009 and did nothave a significant impact on the Corporation’s financial statements.

 

InJuly 2009, FASB issued SFAS No. 168, “The FASB Accounting StandardsCodification and the Hierarchy of Generally Accepted Accounting Principles, aReplacement of FASB Statement No. 162”**(“SFAS 168”).  SFAS 168 replaces SFAS No. 162,“The Hierarchy of Generally Accepted Accounting Principles” and establishes theFASB Accounting Standards Codification (the “Codification”) as the source ofauthoritative accounting principles recognized by the FASB to be applied bynon-governmental entities in the preparation of financial statements inconformity with generally accepted accounting principles. Rules andinterpretive releases of the Securities and Exchange Commission (“SEC”) underauthority of federal securities laws are also sources of authoritative guidancefor SEC registrants. All guidance contained in the Codification carries anequal level of authority. All non-grandfathered, non-SEC accounting literaturenot included in the Codification is superseded and deemed non-authoritative.SFAS 168 will be effective for the Corporation’s financial statements forperiods ending after September 15, 2009 and is not expected to have asignificant impact on the Corporation’s financial statements.

 

In April 2009, the FASB issued SFAS No. 115-2and SFAS No. 124-2, “Recognition and Presentation ofOther-Than-Temporary Impairments” (“SFAS 115-2 and SFAS 124-2”).  SFAS 115-2 and SFAS 124-2 (i) changeexisting guidance for determining whether an impairment is other than temporaryto debt securities and (ii) replace the existing requirement that theentity’s management assert that it has both the intent and ability to hold animpaired security until recovery.  Theyalso require that management assert that (a) it does not have the intentto sell the security and (b) it is more likely than not it will not haveto sell the security before recovery of its cost basis. Under SFAS 115-2and SFAS 124-2, declines in the fair value of held-to-maturity andavailable-for-sale securities below their cost that are deemed to be other thantemporary are reflected in earnings as realized losses to the extent theimpairment is related to credit losses. The amount of the impairment related toother factors is recognized in other comprehensive income. The Corporationadopted the provisions of SFAS 115-2 and SFAS 124-2 during the firstquarter of 2009. Adoption of SFAS 115-2 and SFAS 124-2 did not have asignificant impact on the Corporation’s financial statements.

 

InApril 2009, the FASB issued SFAS No.107-1 and Accounting Principles BoardOpinion (“APB”) No. 28-1, “Interim Disclosures about Fair Value ofFinancial Instruments” (“SFAS 107-1 and APB 28-1”).  SFAS 107-1 and APB 28-1 amend SFAS 107 torequire an entity to provide disclosures about fair value of financialinstruments in interim financial information. They also amend APB No. 28, “Interim Financial Reporting” torequire disclosures of summarized financial information at interim reportingperiods.  Under SFAS 107-1 andAPB 28-1, a publicly traded company must include disclosures about thefair value of its financial instruments whenever it issues summarized financialinformation for interim reporting periods. In addition, entities must disclose,in the body or in the accompanying notes of its summarized financialinformation for interim reporting periods and in its financial statements forannual reporting periods, the fair value of all financial instruments for whichit is practicable to estimate that value, whether recognized or not recognizedin the statement of financial position, as required by SFAS 107. The newinterim disclosures required by SFAS 107-1 and APB 28-1 have been includedin the Corporation’s interim financial statements beginning with the secondquarter of 2009.

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations.**

 

**FORWARD-LOOKING STATEMENTS**

 

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 (the “Exchange Act”). Theseforward-looking statements may be identified by, among other things, the use offorward-looking terminology such as “could,” “would,” “expects,” “believes,” “may”or “will,” or future or conditional verb tenses, and variations or negatives ofsuch terms.  These forward-lookingstatements include, without limitation, those relating to the Corporation’svaluation methodologies, the effect of recent accounting pronouncements, loanportfolio concentrations, repayment of loans by borrowers, satisfaction ofcapital adequacy requirements, the repayment of FHLB borrowings, adequacy ofcapital resources and traditional sources of cash generated from operatingactivities to meet liquidity needs and the realization of deferred income taxassets.  We caution you not to placeundue reliance on such forward-looking statements in this report because resultscould differ materially from those anticipated due to a variety offactors.  These factors include, but arenot limited to, changes in economic conditions; fluctuations in prevailinginterest rates and the effectiveness of our risk monitoring systems; theability of our borrowers to repay loans; adverse changes in our special mentioncredits; our ability to meet regulatory capital adequacy requirements; ourability to meet liquidity needs from operating activities; the accuracy ofassumptions in our rate risk analysis; our ability to recognize deferred taxassets; our ability to maintain credit quality; laws and regulations affectingfinancial institutions in general; our ability to control factors influencingnet interest income; the geographic concentration of our assets; our ability tomaintain sufficient asset quality and cost controls; and other factorsgenerally understood to affect the financial results of financial servicescompanies and other factors detailed from time to time in our filings with theSEC. We undertake no obligation to update these forward-looking statements toreflect events or circumstances that occur after the date of this report.

 

**EXECUTIVE OVERVIEW**

 

AtJune 30, 2009, theconsolidated total assets of the First Farmers and Merchants Corporation (the “Corporation”)were $943.3 million, its consolidated net loans were $590.3 million, its totaldeposits were $786.4 million and its total shareholders’ equity was $104.0million.  The Corporation’s loanportfolio at June 30,2009 reflected an increase of $3.4 million, or 0.6%, compared to December 31,2008.  Total deposits increased $41.5million and shareholders’ equity decreased 3.0% during the first six months of2009.  Total shareholders’ equityincludes an unrealized loss on available-for-sale securities of approximately$1.4 million.

 

**FINANCIALCONDITION**

 

Averageearning assets at June 30,2009 were up 6.6%, or $51.7 million, from average earning assets at December 31,2008.  Average overnight investments at June 30, 2009 were up $9.1million compared to December 31, 2008. Average investment securities at June 30, 2009 were down 5.9% compared to December 31,2008, although total investment securities at June 30, 2009 were up $5.7million compared to December 31, 2008. Average total assets of $913.4 million at June 30, 2009 increased 6.8% or $58.1million, compared to $855.3 million at December 31, 2008.

 

**Securities**

 

Available-for-salesecurities are an integral part of the asset/liability management process forFirst Farmers and Merchants Bank, the Corporation’s sole direct subsidiary (the“Bank”).  Accordingly, they represent animportant source of liquidity available to fund loans and accommodate assetreallocation strategies dictated by changes in the Bank’s operating and taxplans, shifting yield spread relationships and changes in configuration of theyield curve.  At June 30, 2009, the Bank’sinvestment securities portfolio had $188.0 million available-for-salesecurities, which are valued at fair market value, and $51.6 millionheld-to-maturity securities, which are valued at cost on the balance sheet.These compare to $174.5 million of available-for-sale securities and $59.4million of held-to-maturity securities as of December 31, 2008.

 

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**Loans**

 

The loan portfolio is the largest component ofearning assets for the Bank and, consequently, provides the highest amount of revenues for theCorporation.  The loan portfolio also contains thehighest exposure to risk as a result of the possibility of unexpecteddeterioration in the credit quality of borrowers.  When analyzing potential loans, management ofthe Bank assesses both interest rate objectives and credit quality objectivesin determining whether to make a given loan and the appropriate pricing forthat loan.  All loans are expected to berepaid from cash flow or proceeds from the sale of selected assets of theborrowers.  Collateral requirements forthe loan portfolio are based on credit evaluation of the borrowers.

 

Theportfolio experienced positive loan growth for the fifth time in sixquarters.  Despite this positive trend,overall loan growth has been sluggish in 2009 and remains short of forecastedgrowth estimates for the year.  The homeequity line of credit portfolio has grown in each of the first two quarters of2009, as it continues to provide the low-cost funding mechanism in thisinterest rate environment.  Althoughthere is not an industry concentration as measured by regulatory guidelineswithin the Bank’s loan portfolio, the Bank currently has heavy exposure in fivebroad industry categories: real estate renting and leasing; religiousorganizations; trucking; physicians; 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 77.0% of total loans at June 30, 2009 compared to 79.0% at June 30,2008 and 76.6% at December 31,2008.  Management of the Bankbelieves the risk of this concentration is acceptable given the quality ofunderwriting and the low level of historical loss experience.  The Bank’s construction and developmentportfolio has shrunk dramatically in 2009, falling by $16.0 million in the lastsix months, as existing construction projects have been completed and few newprojects have been brought online to replace them.  Construction and development loansrepresented only 4.8% of total loans as of June 30, 2009, compared to 9.3%at June 30, 2008.

 

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 $8.2 million, or 1.4% of gross loans and leases, at June 30, 2009, compared to$8.6 million, or 1.4%, at December 31, 2008.  Net charge-offs through June 30, 2009 were $1.8million, which results in an annualized net charge-off ratio of 0.6%.

 

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 June 30, 2009, this process identifiedloans totaling $8.2 million, or 1.4% of the portfolio, that were classified asother assets especially mentioned, compared to loans totaling $9.9 million, or1.7% of the portfolio, so classified at December 31, 2008.  Loans totaling $28.2 million, or 4.7% of theportfolio, were classified as substandard at June 30, 2009, compared to loans totaling$26.1 million, or 4.4% of the portfolio, so classified at December 31,2008.  No loans were classified asdoubtful at June 30,2009 and December 31, 2008.

 

**Deposits**

 

The Bank does not have anyforeign offices and all deposits are serviced in its 19 domestic offices.  The Bank’s average deposits increased 7.0%during the first six months of 2009 compared to an increase of 1.1% in thefirst six months of 2008.  The increaseresults from the Bank offering more competitive rates on money marketaccounts.  Average totalnoninterest-bearing deposits were 15.4% of total deposits at June 30, 2009, contributingto the Bank’s low cost of deposits, compared to 17.1% at December 31,2008.

 

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**Regulatory Requirements 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 certainoff-balance-sheet items as calculated under regulatory accountingpractices.  The capital classification isalso subject to qualitative judgments by the regulators about components, riskweightings and other 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%.  At June 30, 2009, the Corporation’s Tier 1,Total Capital and leverage capital ratios were 14.9%, 16.1% and 10.7 %,respectively.  The ratios were 15.3%,16.5% and 10.9%, respectively, at December 31, 2008.  As of June 30, 2009, the Bank’s Tier 1 Capital,Total Capital and leverage capital were 14.6%, 15.8%, and 10.4%, respectively,compared to 15.0%, 16.2%, and 10.6% at December 31, 2008. Managementbelieves, as of June 30,2009, that the Corporation and the Bank each met all capital adequacyrequirements to which they are subject.

 

**LIQUIDITY AND CAPITAL****RESOURCES**

 

 Most of the capital needs of theBank historically have been financed with retained earnings and depositsreceived, and the Corporation’s primary source of liquidity has been dividendsdeclared by the Bank.  In March 2008,the Bank obtained five advances at $7 million each from the FHLB.  The first scheduled repayment of the advanceswas made in March 2009.  Theremaining payments will continue through 2013.  In September 2008, the Bank obtained two additional advances of$3.1 million each for a total borrowing for 2008 of $41.2 million.  The borrowings from the FHLB helped fundinvestment strategies to enhance the Bank’s portfolio.   Please refer to Note 4 in the notes toconsolidated financial statements for additional information about borrowingsfrom the FHLB and the repayment schedule of such borrowings.

 

 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 $0.365 per share dividend in the secondquarter of 2009, which will be paid in the third quarter of 2009.  Management believes that the Corporation’straditional sources of cash generated from the Bank’s operating activities areadequate to meet the Corporation’s liquidity needs for normal ongoing operations.  The Bank’s Board of Directors has adopted aliquidity policy that outlines specific liquidity target balances.  Compliance with this policy is reviewedquarterly by the Bank’s Asset/Liability Committee and results are reported tothe Bank’s Board of Directors.

 

TheBank’s formal asset and liability management process is used to controlinterest rate risk and assist management in maintaining reasonable stability inthe gross interest margin as a result of changes in the level of interest ratesand/or the spread relationships among interest rates.  The Bank uses an earnings simulation model toevaluate the impact of different interest rate scenarios on the grossmargin.  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 and interestbearing liabilities are financial instruments that can be repriced to currentmarket rates within a defined time period.

 

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**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 June 30,2009, the deferred income tax asset was $6.3 million, compared to $4.9 millionat December 31, 2008, and was included with other assets on the balancesheet.

 

*Allowance for Loan and LeaseLosses*

 

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 implemented procedures thatgive more detailed historical data by category of retail and consumer creditand performance characteristics to broaden the analysis and improve monitoringof potential credit risk.

 

Criteria considered and processes utilized in evaluating the adequacyof 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.

 

*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.

 

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**OFF-BALANCESHEET ARRANGEMENTS**

 

TheBank is a party to financial instruments with off-balance-sheet risk in thenormal course of business to meet the financing needs of its customers.  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 in 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 letters ofcredit 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 June 30,2009 were $108.3 million and $9.5 million, respectively, compared to $100.1million and $17.1 million, respectively, at June 30, 2008.

 

AtJune 30, 2009, theCorporation and the Bank did not have any off-balance sheet arrangements otherthan commitments to extend credit and stand-by letters of credit.

 

**RESULTS OF OPERATIONS**

 

Totalinterest income for the first six months of 2009 was $20.3 million compared to$22.0 million for the first six months of 2008 and $10.0 million for the threemonths ended June 30, 2009 compared to $11.0 million for the three monthsended June 30, 2008.  Interest andfees earned on loans and investments are the components of total interestincome.  Interest and fees earned onloans were $15.8 million, a decrease of approximately $700,000, or 4.2%, duringthe first six months of 2009 compared to the first six months of 2008, and $7.9million for the three months ended June 30, 2009, a decrease of $231,000,or 2.8%, compared to the three months ended June 30, 2008.  Nominal interest earned on investmentsecurities and other investments was $4.5 million, a decrease of approximately$894,000, or 16.7%, during the first six months of 2009 compared to the firstsix months of 2008, and $2.1 million for the three months ended June 30,2009, a decrease****of $656,000, or 23.7%, comparedto the three months ended June 30, 2008.

 

Total interest expense in the first six months of 2009 was $4.9million, a decrease of $1.6 million, or 24.3%, compared to the first six monthsof 2008, and $2.4 million for the three months ended June 30, 2009, a****decrease of approximately $748,000 compared to the threemonths ended June 30, 2008.  Thelower interest rates for certificates of deposits and public funds during thesecond quarter of 2009 were the primary reason for the lower expense.  As a policy, budgeted financial goals aremonitored on a monthly basis by the Bank’s Asset/Liability Committee, whichreviews the actual dollar change in net interest income for different interestrate movements.  A negative dollar changein net interest income for a 12-month and 24-month period of less than 10.0% ofnet interest income given a 100 to 200 basis point shift in interest rates isconsidered an acceptable rate risk position. The rate risk analysis for the 12-month period beginning July 1,2009 and ending June 30, 2010 showed a worst-case potential change to netinterest income of 1.9%, or an increase in net interest income of approximately$640,000 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 and mixof earning assets and sources of funding;

(2)           market rates ofinterest; and

(3)           income tax rates.

 

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.

 

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The net interest margin, on a tax equivalent basis, at June 30, 2009, June 30, 2008 and December,31, 2008 was 4.01%, 4.40% and 4.40%, respectively.

 

Additions of $770,000 were made to the provision for possible loan andlease losses in the second quarter of 2009 as a result of an increase in thelevel of credit losses on both secured and unsecured consumer loans as well asa downgrade of the credit level on a few commercial loans.

 

Noninterest incomewas $7.6 million, an increase of approximately $768,000, or 11.2%, during thefirst six months of 2009 compared to the first six months of 2008, and $3.2million for the three months ended June 30, 2009, an****increaseof approximately $102,000 compared to the three months ended June 30, 2008. The gains on sales of available-for-sale securities, representing $2.5million in income, was the primary reason for the increase.

 

Noninterestexpenses, excluding the provision for possible loan and lease losses, wereapproximately $395,000, or 2.5%, higher in the first six months of 2009 ascompared to the first six months of 2008. ** **The Bank expensed approximately $750,000 for theFederal Deposit Insurance Company (“FDIC”) special assessment and also theincrease in the FDIC’s regular assessment for the first six months of 2009.

 

The Corporation does not have any long-term debt or other long-termobligations; however, in 2008, the Bank received a $41.2 million advance fromFHLB.   The scheduled $7.0 million annual principal maturities ofborrowings under this credit line began in March 2009 and will end in2013.  Please refer to Note 4 in thenotes to consolidated financial statements for additional information aboutborrowings from the FHLB.

 

TheBank also leases certain of its properties. There was not a change during the six-month period ended June 30, 2009 in the termsof these leases.

 

Netincome for the six months ended June 30, 2009 was $4.4 million, comparedto $5.3 million for the six months ended June 30, 2008.  A decrease in interest income on loans andsecurities contributed to the period-over-period decrease.  The Corporation earned $0.80 per share in thesecond quarter of 2009 and $0.93 per share in the second quarter of 2008.

 

**Item3.  Quantitative and QualitativeDisclosures About Market Risk.**

 

Duringthe six months ended June 30,2009, 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, 2008.

 

**Item4.  Controls and Procedures.**

 

(a) Evaluationof Disclosure Controls and Procedures. The Corporation, with the participation of its management, including theCorporation’s Chief Executive Officer and Assistant Treasurer (principalfinancial officer), carried out an evaluation of the effectiveness of thedesign and operation of its disclosure controls and procedures (as defined in Rules 13a-15and 15d-15 under the Exchange Act) as of the end of the period covered by thisreport.  Based upon that evaluation andas of the end of the period covered by this report, the Corporation’s ChiefExecutive Officer and Assistant Treasurer (principal financial officer)concluded that the Corporation’s disclosure controls and procedures wereeffective in ensuring that information required to be disclosed in its reportsthat the Corporation files or submits to the SEC under the Exchange Act isrecorded, processed, summarized and reported on a timely basis.

 

(b) Changesin Internal Control Over Financial Reporting.  There has been no change in the Corporation’sinternal control over financial reporting that occurred during the secondquarter of 2009 that has materially affected, or is reasonably likely tomaterially affect, the Corporation’s internal control over financial reporting.

 

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**PART II- OTHER INFORMATION**

 

**Item1A. 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, 2008.

 

**Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds.**

 

The following table provides information regarding purchases of theCorporation’s common stock made by the Corporation during the second quarter of2009:

** **

**CORPORATION’SPURCHASES 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** | ** ** |
|-----------------------------------------------|------------|----------------------------------------|------------|------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------|------------|
| April 1, 2009 – April 30, 2009 |       | —                                 |       | —                             |       | —                                                                                        |       | —                                                                                                                         |       |
| May 1, 2009 – May 31, 2009     |       | —                                 |       | —                             |       | —                                                                                        |       | —                                                                                                                         |       |
| June 1, 2009 – June 30, 2009   |       | 25,000                                 | *          | $                                  | 50.00      |                                                                                          | —     |                                                                                                                           | —     |   |
| Total                                         |       | 25,000                                 |       | $                                  | 50.00      |                                                                                          | —     |                                                                                                                           | —     |   |

 

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*Purchased through negotiated transactions with several****third-party sellers.

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders.**

 

The annual meeting forshareholders of the Corporation was held on April 21, 2009.  At the meeting, the Corporation’sshareholders voted to elect directors. At the meeting, votes were cast asfollows:

 
| ** **                          | ** ** | **Votes For** | ** ** | **Votes Withheld** | ** ** | **Abstentions/Broker  Non-Votes** | ** ** |
|-------------------------------------|------------|---------------|------------|--------------------|------------|-----------------------------------|------------|
| Kenneth  A. Abercrombie             |       | 3,726,860     |       | 10,832             |       | 1,842,308                         |       |
| James  L. Bailey, Jr.          |       | 3,732,407     |       | 5,285              |       | 1,842,308                         |       |
| M.  Darlene Baxter                  |       | 3,736,704     |       | 988                |       | 1,842,308                         |       |
| H.  Terry Cook, Jr.            |       | 3,735,892     |       | 1,800              |       | 1,842,308                         |       |
| Thomas  Napier Gordon               |       | 3,689,310     |       | 48,382             |       | 1,842,308                         |       |
| Dr. O.  Rebecca Hawkins        |       | 3,733,716     |       | 3,976              |       | 1,842,308                         |       |
| Timothy  E. Pettus                  |       | 3,714,137     |       | 23,555             |       | 1,842,308                         |       |
| Dr. Joseph  W. Remke, III |       | 3,734,608     |       | 3,084              |       | 1,842,308                         |       |
| Matthew  M. Scoggins, Jr.      |       | 3,737,384     |       | 308                |       | 1,842,308                         |       |
| T.  Randy Stevens                   |       | 3,736,704     |       | 988                |       | 1,842,308                         |       |
| W.  Lacy Upchurch                   |       | 3,737,384     |       | 308                |       | 1,842,308                         |       |
| William  R. Walter                  |       | 3,736,492     |       | 1,200              |       | 1,842,308                         |       |
| Dan  C. Wheeler                     |       | 3,736,492     |       | 1,200              |       | 1,842,308                         |       |
| Dr. David  S. Williams         |       | 3,735,288     |       | 2,404              |       | 1,842,308                         |       |
| W.  Donald Wright                   |       | 3,736,492     |       | 1,200              |       | 1,842,308                         |       |

 

18

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As indicated in the abovetable, Kenneth A. Abercrombie, James L. Bailey, Jr., M. Darlene Baxter, H.Terry Cook, Jr., Thomas Napier Gordon, Dr. O. Rebecca Hawkins,Timothy E. Pettus, Dr. Joseph W. Remke, III, Matthew M. Scoggins, Jr.,T. Randy Stevens, W. Lacy Upchurch, William R. Walter, Dan C. Wheeler, Dr. DavidS. Williams and W. Donald Wright were elected as directors of the Corporation.The terms of the directors will continue until the annual meeting ofshareholders in 2010, or until their respective successors are elected andqualified.

 

**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. |
|        |       |            |   |
| 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 from the First Farmers and MerchantsCorporation Amendment No. 1 to the Annual Report on Form 10-K/A forthe year ended December 31, 2003, as filed with the Securities andExchange Commission on May 7, 2004 (File Number 000-10972).

 

(2)  Incorporated by reference from the First Farmers andMerchants Corporation Current Report on Form 8-K, as filed with theSecurities and Exchange Commission on April 23, 2007 (File Number000-10972).

 

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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                                     | August 7, 2009 |   | /s/ T. Randy  Stevens |
|                                     |   | T. Randy  Stevens, Chief Executive Officer |
|                                     |   |   |
|                                     |   |   |
| Date                                     | August 7, 2009 |   | /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 from the First Farmers andMerchants Corporation Amendment No. 1 to the Annual Report on Form 10-K/Afor the year ended December 31, 2003, as filed with the Securities andExchange Commission on May 7, 2004 (File Number 000-10972).

 

(2)  Incorporated by reference from the First Farmers andMerchants Corporation Current Report on Form 8-K, as filed with theSecurities and Exchange Commission on April 23, 2007 (File Number000-10972).

 

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