**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**FOR THEQUARTERLY PERIOD ENDED SEPTEMBER 30, 2007**

 

**CommissionFile Number 000-50921**

 

**SOUTHERNHERITAGE BANCSHARES, INC.**

(Exact Name of RegistrantAs Specified in Its Charter)

 

| **Tennessee**                    | **42-1627829**                     |
|----------------------------------|------------------------------------|
| (State or Other  Jurisdiction of | (IRS Employer  Identification No.) |
| Incorporation or  Organization)  |                               |

 

**3020 Keith Street, NW**

**Cleveland, Tennessee  37312**

(Address of PrincipalExecutive Offices and Zip Code)

 

**(423) 473-7980**

(Registrant’s TelephoneNumber, Including Area Code)

 

**NotApplicable**

(Former name, formeraddress and former fiscal year if changes since last report)

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

Yes x                Noo

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): 

| Large  Accelerated Filer o |   | Accelerated  Filer o |   | Non-accelerated  Filer x |
|----------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes o                No x

 

As of September 30, 2007 there were 1,224,389 sharesof common stock issued and outstanding.

 

 

 

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**SouthernHeritage Bancshares, Inc.**
| Table  of Contents |                                                                                        |
|--------------------|---------------------------------------------------------------------------------------------|
| PART  I:           | FINANCIAL  INFORMATION                                                                      | 3 |
| ITEM  1:           | FINANCIAL  STATEMENTS                                                                       | 3 |
| ITEM 2:            | MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL  CONDITION AND RESULTS OF OPERATIONS | 12 |
| ITEM 3:            | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET  RISK                                 | 16 |
| ITEM  4:           | CONTROLS  AND PROCEDURES                                                                    | 19 |
| PART  II:          | OTHER  INFORMATION                                                                          | 20 |
| ITEM  1:           | LEGAL  PROCEEDINGS                                                                          | 20 |
| ITEM  1A:          | RISK  FACTORS                                                                               | 20 |
| ITEM 2:            | UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF  PROCEEDS                                | 20 |
| ITEM 3:            | DEFAULTS UPON SENIOR SECURITIES                                                             | 20 |
| ITEM 4:            | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                         | 20 |
| ITEM  5:           | OTHER  INFORMATION                                                                          | 21 |
| ITEM 6:            | EXHIBITS                                                                                    | 21 |
| SIGNATURES         |                                                                                        |

 

2

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**PART I — FINANCIAL INFORMATION**

**ITEM 1. FINANCIAL STATEMENTS**

**SOUTHERN HERITAGE BANCSHARES, INC.Consolidated Balance Sheets**

($ amounts in thousands except share and earnings per share)
| ** **                                                                                                                             | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ***Assets***                                                                                                                           |       |                         |       |                        |       |
| Cash and due from banks                                                                                                                | ** ** | $                            | 4,199      |                        | 5,165      |   |
| Federal funds sold                                                                                                                     |       | 7,300                        |       | 12,288                      |       |
| ***Cash and cash equivalents***                                                                                                        |       | 11,499                       |       | 17,453                      |       |
| Securities available-for-sale, at fair value                                                                                           |       | 45,244                       |       | 28,746                      |       |
| Mortgage loans held for sale                                                                                                           |       | 962                          |       | 2,538                       |       |
| Loans                                                                                                                                  |       | 154,966                      |       | 162,114                     |       |
| Allowance for loan losses                                                                                                              |       | (4,829                       | )          | (1,971                      | )          |
| ***Loans, net***                                                                                                                       |       | 150,137                      |       | 160,143                     |       |
| Premises and equipment                                                                                                                 |       | 5,137                        |       | 5,177                       |       |
| Restricted stock                                                                                                                       |       | 830                          |       | 830                         |       |
| Accrued income receivable                                                                                                              |       | 1,227                        |       | 1,043                       |       |
| Other assets                                                                                                                           |       | 2,447                        |       | 2,254                       |       |
|                                                                                                                                   | ** ** | $                            | 217,483    |                        | 218,184    |   |
|                                                                                                                                   |       |                         |       |                        |       |
| ***Liabilities and Shareholders’  Equity***                                                                                       |       |                         |       |                        |       |
| **Liabilities:**                                                                                                                       |       |                         |       |                        |       |
| **Deposits:**                                                                                                                          |       |                         |       |                        |       |
| Noninterest-bearing                                                                                                                    | ** ** | $                            | 25,974     |                        | 26,265     |   |
| Interest-bearing                                                                                                                       |       | 167,944                      |       | 164,758                     |       |
| ***Total deposits***                                                                                                                   |       | 193,918                      |       | 191,023                     |       |
| Repurchase agreements                                                                                                                  |       | 220                          |       | 332                         |       |
| FHLB advance                                                                                                                           |       | 0                            |       | 3,000                       |       |
| Accrued interest payable                                                                                                               |       | 1,569                        |       | 1,494                       |       |
| Subordinated debentures                                                                                                                |       | 5,155                        |       | 5,155                       |       |
| Other liabilities                                                                                                                      |       | 414                          |       | 270                         |       |
| ***Total liabilities***                                                                                                                |       | 201,276                      |       | 201,274                     |       |
| **Shareholders’ equity:**                                                                                                         |       |                         |       |                        |       |
| Preferred stock, no par value. Authorized 1,000,000  shares; none issued                                                               |       | —                       |       | —                      |       |
| Common stock, $1 par value. Authorized 2,000,000  shares; 1,224,389 shares issued at September 30, 2007 and 1,164,996 at Dec  31, 2006 |       | 1,224                        |       | 1,164                       |       |
| Additional paid-in-capital                                                                                                             |       | 15,412                       |       | 13,074                      |       |
| Retained earnings (accumulated deficit)                                                                                                |       | (100                         | )          | 2,885                       |       |
| Accumulated other comprehensive loss                                                                                                   |       | (329                         | )          | (213                        | )          |
| ***Total shareholders’ equity***                                                                                                  |       | 16,207                       |       | 16,910                      |       |
|                                                                                                                                   | ** ** | $                            | 217,483    |                        | 218,184    |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

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**SOUTHERN HERITAGE BANCHARES, INC.Consolidated Statements of Operations**

($ amounts in thousands except share and earnings per share)
| ** **                                                 | ** ** | **Three Months Ended Sept 30** | ** ** | **Nine Months Ended Sept 30** | ** ** |
|------------------------------------------------------------|------------|--------------------------------|------------|-------------------------------|------------|
| ** **                                                 | ** ** | **2007**                       | ** ** | **2006**                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Interest income:**                                       | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Loans, including fees                                      | ** ** | **$**                          | **3,019**  |                          | 3,080      | ** ** | **$** | **9,092** |   | 8,565 |   |
| Securities                                                 | ** ** | **470**                        |       | 285                           | ** ** | **1,217** |   | 800 |   |
| Federal funds sold                                         | ** ** | **137**                        |       | 137                           | ** ** | **544** |   | 312 |   |
| ***Total  interest income***                               | ** ** | **3,626**                      |       | 3,502                         | ** ** | **10,853** |   | 9,677 |   |
| **Interest expense:**                                      | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                                                   | ** ** | **1,784**                      |       | 1,488                         | ** ** | **5,390** |   | 3,878 |   |
| Other borrowed funds                                       | ** ** | **103**                        |       | 143                           | ** ** | **318** |   | 326 |   |
| ***Total  interest expense***                              | ** ** | **1,887**                      |       | 1,631                         | ** ** | **5,708** |   | 4,204 |   |
| ***Net  interest income***                                 | ** ** | **1,739**                      |       | 1,871                         | ** ** | **5,145** |   | 5,473 |   |
| **Provision for loan losses**                              | ** ** | **500**                        |       | 267                           | ** ** | **2,940** |   | 435 |   |
| ***Net  interest income after provision for loan losses*** | ** ** | **1,239**                      |       | 1,604                         | ** ** | **2,205** |   | 5,038 |   |
| **Noninterest income:**                                    | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service charges on deposit  accounts                       | ** ** | **234**                        |       | 261                           | ** ** | **669** |   | 815 |   |
| Mortgage banking  activities                               | ** ** | **174**                        |       | 165                           | ** ** | **493** |   | 512 |   |
| Gain (loss) on sale of  securities                         | ** ** | **8**                          |       | 183                           | ** ** | **11** |   | 196 |   |
| Other service charges,  commissions and fees               | ** ** | **139**                        |       | 62                            | ** ** | **374** |   | 218 |   |
| ***Total  noninterest income***                            | ** ** | **555**                        |       | 671                           | ** ** | **1,547** |   | 1,741 |   |
| **Noninterest expenses:**                                  | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Salaries and employee  benefits                            | ** ** | **845**                        |       | 792                           | ** ** | **2,448** |   | 2,276 |   |
| Occupancy expense                                          | ** ** | **109**                        |       | 102                           | ** ** | **307** |   | 294 |   |
| Other operating expenses                                   | ** ** | **773**                        |       | 561                           | ** ** | **2,252** |   | 1,684 |   |
| ***Total  noninterest expenses***                          | ** ** | **1,727**                      |       | 1,455                         | ** ** | **5,007** |   | 4,254 |   |
| ***Income  (loss) before income taxes***                   | ** ** | **67**                         |       | 820                           | ** ** | **(1,255** | ) | 2,525 |   |
| **Income tax expense (benefit)**                           | ** ** | **4**                          |       | 265                           | ** ** | **(615** | ) | 846 |   |
| ***Net  income (loss)***                                   | ** ** | **63**                         |       | 555                           | ** ** | **(640** | ) | 1,679 |   |
|                                                       |       |                           |       |                          |       |   |   |   |   |
| **Other comprehensive income  (loss):**                    | ** ** | ** **                     | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unrealized gains/losses on  securities                     | ** ** | **674**                        |       | 278                           | ** ** | **(329** | ) | 140 |   |
|                                                       |       |                           |       |                          |       |   |   |   |   |
| **Comprehensive income (loss)**                            | ** ** | **737**                        |       | 833                           | ** ** | **(969** | ) | 1,819 |   |
|                                                       |       |                           |       |                          |       |   |   |   |   |
| Basic earnings (loss) per  share                           | ** ** | **$**                          | **0.05**   |                          | $          | 0.45 | ** ** | **$** | **(0.52** | **)** | **$** | **1.39** | ** ** |
| Diluted earnings (loss)  per share                         | ** ** | **$**                          | **0.05**   |                          | $          | 0.43 | ** ** | **$** | **N/A** | ** ** | **$** | **1.31** | ** ** |
|                                                       |       |                           |       |                          |       |   |   |   |   |
| Shares used in computation  of earnings per share          |       |                           |       |                          |       |   |   |   |   |
| Basic                                                      | ** ** | **1,224,389**                  |       | 1,222,826                     | ** ** | **1,223,559** |   | 1,209,151 |   |
| Diluted                                                    | ** ** | **1,304,857**                  |       | 1,297,358                     | ** ** | **1,223,559** |   | 1,283,683 |   |

 

Seeaccompanying notes to consolidated financial statements.

 

4

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**SOUTHERN HERITAGE BANCSHARES, INC.Consolidated Statements of Cash Flows**

($ amounts in thousands)
| ** **                                                                      | ** ** | **September 30,  2007** | ** ** | **September 30,  2006** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| Cash flows from operating  activities                                           |       |                    |       |                    |       |
| Net (loss) income                                                               |       | $                       | (640       | )                       | $          | 1,679 |   |
| Adjustments to reconcile  net income/loss to net cash from operating activities |       |                    |       |                    |       |
| Provision for loan losses                                                       |       | 2,940                   |       | 435                     |       |
| Depreciation and  amortization                                                  |       | 407                     |       | 303                     |       |
| Investment securities  (gains) losses                                           |       | (11                     | )          | (196                    | )          |
| Mortgage loans originated  for sale                                             |       | (21,999                 | )          | (22,446                 | )          |
| Proceeds from sale of  mortgage loans                                           |       | 24,068                  |       | 21,238                  |       |
| Gains on sales of mortgage  loans                                               |       | (493                    | )          | (512                    | )          |
| Loss on sale of other real  estate                                              |       | 58                      |       | —                  |       |
| Stock compensation expense                                                      |       | 34                      |       | 36                      |       |
| Tax benefit from the  exercise of stock options                                 |       | (13                     | )          | —                  |       |
| Changes in operating  assets and liabilities:                                   |       |                    |       |                    |       |
| (Increase) decrease in  accrued interest receivable                             |       | (184                    | )          | (139                    | )          |
| Increase (decrease) in  accrued interest payable                                |       | 75                      |       | 338                     |       |
| Other, net                                                                      |       | 52                      |       | (111                    | )          |
| Net cash provided by  operating activities                                      |       | 4,294                   |       | 625                     |       |
|                                                                            |       |                    |       |                    |       |
| Cash flows from investing  activities                                           |       |                    |       |                    |       |
| Proceeds from maturities  and redemptions of securities available for sale      |       | 1,082                   |       | 787                     |       |
| Proceeds from sales of  securities available for sale                           |       | 1,626                   |       | 6,384                   |       |
| Purchases of securities  available for sale                                     |       | (19,423                 | )          | (6,777                  | )          |
| Purchases of restricted  equity securities                                      |       | —                  |       | (24                     | )          |
| Net decrease (increase) in  loans                                               |       | 5,741                   |       | (10,415                 | )          |
| Proceeds from sale of  other real estate                                        |       | 1,242                   |       | —                  |       |
| Net purchases of premises  and equipment                                        |       | (318                    | )          | (165                    | )          |
| Net cash (used in)  provided by investing activities                            |       | (10,050                 | )          | (10,210                 | )          |
|                                                                            |       |                    |       |                    |       |
| Cash flows from financing  activities                                           |       |                    |       |                    |       |
| (Decrease) increase in  repurchase agreements and federal funds purchased       |       | (112                    | )          | 5                       |       |
| (Decrease) increase in  Federal Home Loan Bank Advances                         |       | (3,000                  | )          | 3,000                   |       |
| Proceeds from exercise of  stock options                                        |       | 20                      |       | 266                     |       |
| Tax Benefit from the  exercise of stock options                                 |       | 13                      |       | —                  |       |
| Dividends Paid                                                                  |       | (14                     | )          | (9                      | )          |
| Net increase in deposits                                                        |       | 2,895                   |       | 11,089                  |       |
| Net cash (used in)  provided by financing activities                            |       | (198                    | )          | 14,351                  |       |
|                                                                            |       |                    |       |                    |       |
| Net increase (decrease) in  cash and cash equivalents                           |       | (5,954                  | )          | 4,766                   |       |
|                                                                            |       |                    |       |                    |       |
| Cash and cash equivalents  at beginning of period                               |       | 17,453                  |       | 7,078                   |       |
|                                                                            |       |                    |       |                    |       |
| Cash and cash equivalents  at end of period                                     |       | $                       | 11,499     |                    | $          | 11,844 |   |
|                                                                            |       |                    |       |                    |       |
| Supplemental disclosures  of cash flow information                              |       |                    |       |                    |       |
| Cash paid during period  for:                                                   |       |                    |       |                    |       |
| Interest                                                                        |       | $                       | 5,633      |                    | $          | 3,866 |   |
| Income taxes                                                                    |       | 57                      |       | 980                     |       |
| Loans transferred to other  real estate acquired through foreclosure            |       | 1,327                   |       | —                  |       |

 

See accompanying notes to consolidated financial statements.

5

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**SOUTHERN HERITAGE BANCSHARES, INC.Notes to Consolidated Financial StatementsSeptember 30, 2007(Unaudited)**

*Basis of Presentation*

Theaccompanying financial statements have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q. Accordingly they do not include allinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.

Theconsolidated financial statements include Southern HeritageBancshares, Inc. and its wholly owned subsidiary, Southern Heritage Bank,together referred to as “the Company”. Intercompany transactions and balancesare eliminated in consolidation.

SouthernHeritage Bancshares, Inc. is a one bank holding company that owns 100% ofSouthern Heritage Bank (the Bank). Substantially all of the consolidatedoperations are that of the Bank.

Inthe opinion of management, the financial statements contain all adjustmentsnecessary to summarize fairly the financial position of the Bank as ofSeptember 30, 2007, the results of operations for the three and nine monthsended September 30, 2007, and cash flows for the nine months ended September30, 2007. The interim financial statements should be read in conjunction withthe notes to the financial statements presented in the Bank’s December 31,2006, financial statements. The results for the interim periods are notnecessary indicative of the results to be expected for the complete year.

*Allowance for Loan Losses*

Transactions in the allowance for loan losses were as follows:
| ** **                       | ** ** | **Nine Months Ended  September 30, 2007** | ** ** | **Nine Months Ended  September 30, 2006** | ** ** |
|----------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                       | ** ** | **(In Thousands)**                             | ** ** | **(In Thousands)**                             | ** ** |
|                             |       |                                                |       |                                                |       |
| Balance January 1           |       | $                                                   | 1,971      |                                                | $          | 2,036 |   |
|                             |       |                                                |       |                                                |       |
| Add (deduct):                    |       |                                                |       |                                                |       |
| Losses charged to allowance      |       | (148                                                | )          | (271                                                | )          |
| Recoveries credited to allowance |       | 66                                                  |       | 20                                                  |       |
| Provision for loan losses        |       | 2,940                                               |       | 435                                                 |       |
|                             |       |                                                |       |                                                |       |
| Balance September 30             |       | $                                                   | 4,829      |                                                | $          | 2,220 |   |

 

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Thefollowing table presents various categories of loans contained in the Company’sloan portfolio for the periods indicated and the total amount of all loans forsuch period:
| ** **                             | ** ** | **As of**                 | ** ** |
|----------------------------------------|------------|--------------------------------|------------|
| ** **                             | ** ** | **September  30,********2007** | ** ** | **December 31,  2006** | ** ** |
| ** **                             | ** ** | **($ in thousands)** | ** ** |
| Domestic:                              |       |                           |       |   |   |
|                                   |       |                           |       |   |   |
| Commercial, financial and agricultural |       | $                              | 52,960     |   | $ | 53,953 |   |
| Real estate — construction        |       | 26,223                         |       | 28,464 |   |
| Real estate — family residential  |       | 24,351                         |       | 24,835 |   |
| Real estate — commercial          |       | 46,128                         |       | 49,996 |   |
| Consumer                               |       | 5,304                          |       | 4,866 |   |
| Total loans                            |       | 154,966                        |       | 162,114 |   |
| Allowance for loan losses              |       | (4,829                         | )          | (1,971 | ) |
|                                   |       |                           |       |   |   |
| Total (net of allowance)               |       | $                              | 150,137    |   | $ | 160,143 |   |

 

Thefollowing table presents information regarding nonaccrual, past due,restructured loans and internally classified substandard or doubtful loans atthe dates indicated:
| ** **                                                                                                                         | ** ** | **As of**                     | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                         | ** ** | **September 30,********2007** | ** ** | **December 31,  2006** | ** ** |
| ** **                                                                                                                         | ** ** | **($ in thousands)**     | ** ** |
| Loans accounted for on a non-accrual basis:                                                                                        |       |                               |       |   |   |
| Number                                                                                                                             |       | 3                                  |       | 3 |   |
| Amount                                                                                                                             |       | $                                  | 3,307      |   | 250 |   |
|                                                                                                                               |       |                               |       |   |   |
| Accruing loans (including consumer loans) which are  contractually past due 90 days or more as to principal and interest payments: |       |                               |       |   |   |
| Number                                                                                                                             |       | 3                                  |       | 6 |   |
| Amount                                                                                                                             |       | $                                  | 142        |   | 293 |   |
|                                                                                                                               |       |                               |       |   |   |
| Loans internally classified as substandard or  doubtful                                                                            |       |                               |       |   |   |
| Number                                                                                                                             |       | 37                                 |       | 25 |   |
| Amount                                                                                                                             |       | $                                  | 9,705      |   | 6,376 |   |
|                                                                                                                                    |            |                                    |            |  |  |  |  |

 

Management’sdetermination of the appropriate level of the provision for loan losses and theadequacy of the allowance for loan losses is based, in part on an evaluation ofspecific loans, as well as other factors considered by management, including thecomposition of the loan portfolio, current economic conditions, and thecreditworthiness of the Bank’s borrowers and other related factors.  The increase in the allowance for loan lossesrelates primarily to a group of loans to borrowers controlled by one guarantorthat totaled approximately $6.7 million in the aggregate.  An extensive review and analysis of the loansand their collateral in order to determine their level of impairment andpossible loss was performed.  Based onthis review the Company concluded to increase its allowance for loan lossesthrough an additional provision of approximately $3.0 million. As a result ofthe increase in non-accrual loans, approximately $147 thousand of interestincome was reversed, impacting our yield on loans. See discussion of loaninterest income under “Results of Operations.”

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Asof September 30, 2007, there are no loans classified for regulatory purposes asdoubtful or substandard that have not been disclosed in the above table, which(i) represent or result from trends or uncertainties which managementreasonably expects will materially impact future operating results, liquidity,or capital resources, or (ii) represent material credits about which managementis aware of any information which causes management to have serious doubts asto the ability of such borrowers to comply with the loan repayment terms.

*Stock Compensation*

TheCompany established an Incentive Stock Option Plan (ISO) for officers andemployees and a Non-Employee Directors’ Non-Qualified Stock Option Plan (NQO),which was shareholder approved, effective August 8, 2000, allowing for thegranting of share options and shares to its employees and directors up to153,543 shares of common stock. The Company believes that such awards betteralign the interests of its employees and directors with those of itsshareholders. Option awards are generally granted with an exercise price equalto the market price of the Company’s stock at the date of grant; those optionawards generally vest 20% every two years based on 10 years of continuousservice. Certain option and share awards provide for accelerated vesting ifthere is a change in control (as defined in the Plan).

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option-pricing model. Expected volatilities are based onhistorical exercise patterns, employee terminations and historical stockprices. The expected life of options granted represents the period of time thatoptions granted are expected to be outstanding. The U.S. Treasury 10 yearconstant maturity rate in effect at the date of the grant is used to derive therisk-free interest rate for the contractual period of the options. There wereno options granted in 2007.

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Asummary of option activity under the Plan as of September 30, 2007, and changesduring the nine months then ended is presented below:
| **Options**                         | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Weighted  Average  Intrinsic  Value** | ** ** |
|-------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                          | ** ** | ** ** | ** ** | ** **                             | ** ** | ** **                                          | ** ** | **(In thousands)**                 | ** ** |
| Outstanding at January 1, 2007 |       | 131,813    |       | $                                      | 11.33      |                                                |       |                                    |       |   |
|                                |       |       |       |                                   |       |                                                |       |                                    |       |
| Granted                             |       | —     |       | —                                 |       |                                                |       |                                    |       |
|                                |       |       |       |                                   |       |                                                |       |                                    |       |
| Exercised                           |       | 1,500      |       | 13.45                                  |       |                                                |       |                                    |       |
|                                |       |       |       |                                   |       |                                                |       |                                    |       |
|  Forfeited                     |       | 1,852      |       | 15.57                                  |       |                                                |       |                                    |       |
|                                |       |       |       |                                   |       |                                                |       |                                    |       |
| Outstanding at September 30, 2007   |       | 128,461    |       | $                                      | 11.25      |                                                | 4.43       |                                    | $          | 1,771 |   |
|                                |       |       |       |                                   |       |                                                |       |                                    |       |
| Exercisable at September 30, 2007   |       | 48,223     |       | $                                      | 9.90       |                                                | 3.24       |                                    | $          | 795 |   |

 

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Asof September 30, 2007, there was $192,173 of total unrecognized compensationcost related to nonvested share-based compensation arrangements granted underthe Plan. That cost is expected to be recognized over a weighted-average periodof approximately 5 years. The options under the Plan vest every other year and5,291 shares have vested as of September 30, 2007. However, the compensationcost is recorded on a prorata basis over the entire vesting period resulting intotal compensation cost of $33,840 for the nine months ended September 30, 2007and $36,000 for the same period ended September 30, 2006, based on the fairvalue of the options.

Therewere 1,500 and 28,352 options exercised during the nine months ended September30, 2007 and 2006, respectively.
| ** **                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
|                                            |       |     |       |     |       |
| Intrinsic value of options  exercised           |       | $        | 39,821     |     | $          | 799,087 |   |
| Cash received from option  exercises            |       | 20,179   |       | 265,729  |       |
| Tax benefit realized from  option exercises     |       | 13,539   |       | —   |       |
| Weighted average fair  value of options granted |       | —   |       | —   |       |
|                                                 |            |          |            |          |            |  |  |

 

10

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EarningsPer Share Amounts:  Basicearnings per share is computed using the weighted average number of commonshares outstanding during the period and excludes any dilutive effects ofoptions. Diluted earnings per share is computed using the weighted averagenumber of common and common stock equivalent shares outstanding during theperiod; common stock equivalent shares are excluded from the computation iftheir effect is antidilutive. The effect of these options on earnings percommon share was to increase average shares outstanding by 80,468 and 74,532 in2007 and 2006 and to decrease earnings per share by $.08 for the nine monthsended September 30, 2006. The net loss per share for the nine months endedSeptember 30, 2007 is not reduced for the impact of dilutive shares.  No shares were antidilutive atSeptember 30, 2006.

Recently Issued Accounting Standards on theFinancial Statements:  In July 2006, the FASB releasedInterpretation No. 48, “Accounting for Uncertainty in Income Taxes.”  This Interpretation revises the recognitiontests for tax positions taken in tax returns such that a tax benefit isrecorded only when it is more likely than not that the tax position will beallowed upon examination by taxing authorities.  The amount of such a tax benefitto record is the largest amount that is more likely than not to beallowed.   Any reduction in deferred taxassets or increase in tax liabilities upon adoption will correspondingly reduceretained earnings.

The Company adopted the provisions of FASBInterpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”),on January 1, 2007, and determined there was no need to make an adjustment toretained earnings due to adoption of this Interpretation.  The Company has no unrecognized tax benefitsand does not anticipate any increase in unrecognized benefits during 2007relative to any tax positions taken prior to January 1, 2007.  Should the accrual of any interest orpenalties relative to unrecognized tax benefits to be necessary, it is theCompany’s policy to record such accruals in its income taxes accounts; no such accruals exist as of January 1, 2007.  The Company and its subsidiary file a consolidatedU.S. federal income tax return and a combined unitary return in the state ofTennessee.  These returns are subject toexamination by taxing authorities for all years after 2002.

In September 2006, the FASB issued Statement No.157, Fair Value Measurements.  Thisstatement defines fair value, establishes a framework for measuring fair valueand expands disclosures about fair value measurements.  This Statement establishes a fair valuehierarchy about the assumptions used to measure fair value and clarifiesassumptions about risk and the effect of a restriction on the sale or use of an asset.  The standard iseffective for fiscal years beginning after November 15, 2007.  The Company has not completed its evaluationof the impact of the adoption of this standard.

In February 2007 the FASB issued Statement ofFinancial Accounting Standard (“SFAS”) No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities.” SFAS No. 159 permits entities tochoose to measure many financial instruments and certain other items at fairvalue with an objective of improving financial reporting by providing entitieswith the opportunity to mitigate volatility in reported earnings caused bymeasuring related assets and liabilities differently without having to applycomplex hedge accounting provisions.  Theprovisions of SFAS No. 159 are effective for fiscal years beginning afterNovember 15, 2007.

Inaddition, recently issued accounting standards that revise the accounting forderivatives embedded in other financial instruments and revise the recognitionsand accounting for servicing of financialassets are effective for 2007 but did not have a material effect on thefinancial statements as of and for the nine months ended September 30, 2007.

 

11

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## *ITEM 2:  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS*

 

**FORWARD-LOOKINGSTATEMENTS**

Management’s discussion about us and management’sanalysis of our operations and prospects, and other matters, may includeforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995 and other provisions of federal and statesecurities laws.  Although we believe that the assumptions underlying suchforward-looking statements contained in this report are reasonable, any of theassumptions could be inaccurate and, accordingly, there can be no assurancethat the forward-looking statements included herein will prove to beaccurate.  The use of such words as expect, anticipate, forecast, and comparableterms should be understood by the reader to indicate that the statement is “forward-looking”and thus subject to change in a manner that can be unpredictable.  Factorsthat could cause actual results to differ materially from the resultsanticipated, but not guaranteed, in this report, include (without limitation)economic and social conditions, competition for loans, mortgages, and otherfinancial services and products, changes in interest rates, unforeseen changesin liquidity, results of operations, and financial conditions affecting ourcustomers, as well as other risks that cannot be accurately quantified orcompletely identified.  Many factors affecting our financial condition andprofitability, including changes in economic conditions, the volatility ofinterest rates, political events and competition from other providers offinancial services simply cannot be predicted.  Because these factors areunpredictable and beyond our control, earnings may fluctuate from period toperiod.  The purpose of this type of information is to provide readerswith information relevant to understanding and assessing our financialcondition and results of operations, and not to predict the future or toguarantee results.  We are unable to predict the types of circumstances,conditions, and factors that can cause anticipated results to change.  Weundertake no obligation to publish revised forward-looking statements toreflect the occurrence of changes or unanticipated events, circumstances, orresults.

 

**FINANCIAL CONDITION**

Totalassets as of September 30, 2007 decreased 0.32%, or $701,000 to $217,483,000compared with $218,184,000 at December 31, 2006.  Cash and cash equivalents decreased$5,954,000 to $11,499,000 at September 30, 2007 from $17,453,000 at December31, 2006. Securities increased $16,498,000 to $45,244,000 at September 30, 2007compared to $28,746,000 at December 31, 2006.  The increase in securities was fundedprimarily by the decrease in fed funds sold $4,988,000, decrease in loans$7,148,000, decrease in mortgage loans held for sale $1,576,000, and anincrease in deposits of $2,895,000.  Thedecrease in loans is primarily a result of pay downs in commercial loans anddeclining loan demand.

Loansare the principal component of the Company’s assets and the primary source ofincome. Total loans at September 30, 2007, were $154,966,000 compared to$162,114,000 at December 31, 2006, a decrease of $7,148,000. The decrease inloans in the first nine months of 2007 was as follows: construction real estateloans decreased $2,240,000, commercial loans secured by real estate decreased$3,868,000, commercial loans which decreased $993,000 consumer loans increased$437,000, and loans secured by family residential real estate decreased$484,000.  As of September 30, 2007, $46,128,000 or 29.8% of total loanswere commercial loans secured by real estate. Commercial loans were $52,960,000or 34.2% of total loans. Loans secured by family residential real estate were$24,351,000 or 15.7% of total loans. Construction loans secured by real estatewere $26,223,000 or 16.9% of total loans. Consumer loans were $5,304,000 or3.4% of total loans.  Of the total loans,$98,720,000 or 63.7% mature or reprice within 12 months. Only $6,182,000 or3.99% mature or reprice over five years.

Therewas $962,000 in mortgage loans held for sale at September 30, 2007, comparedwith $2,538,000 at December 31, 2006. The decrease in mortgage loans held forsale was primarily due to timing issues related to secondary market investorfunding.

 

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Managementanticipates that loan demand will be moderate in the near future. Excludingmortgage loans held for sale; the loan-to-deposit ratio as of September 30,2007, was 79.9%, compared to 84.9% at December 31, 2006, and the loan-to-assetsratio was 71.3% at September 30, 2007, compared to 74.3% at December 31, 2006.Management expects that the loan-to-deposit ratio for the remainder of 2007will remain in the range of approximately 75% - 85% and the loans-to-assetsratio will be between 70% - 75%.

Thesecurities portfolio provides a balance to interest rate and credit risk whileproviding a vehicle for investing available funds, furnishing liquidity, andsupplying securities to pledge as required for certain deposits and borrowedfunds. All securities are classified as “available for sale”. We have no plansto liquidate a significant amount of the securities portfolio.  As ofSeptember 30, 2007, the Company owned $45,244,000 of securitiesavailable-for-sale, an increase of $16,498,000 or 57.4% compared to $28,746,000at December 31, 2006.

Depositswhich are the Company’s primary source of funds, totaled $193,918,000 atSeptember 30, 2007, for an increase of $2,895,000, or 1.5%, compared to$191,023,000 at December 31, 2006. Deposits at September 30, 2007 consisted of$25,974,000 or 13.4% in non-interest bearing demand deposits, $39,629,000 or20.4% in interest-bearing demand deposits, $121,307,000 or 62.6% in timecertificates of deposit and $7,008,000 or 3.6% in savings accounts. There was$6,445,000 in brokered CDs at September 30, 2007 compared to $21,526,000 atDecember 31, 2006. The Company has targeted local consumers, professionals, andsmall businesses as its central clientele. These customers are being offeredvarious deposit instruments such as demand deposits, savings accounts, moneymarket accounts, certificates of deposit and IRAs. Rates paid on suchinstruments are set based on various factors such as liquidity needs and marketconditions. The Company believes it has a competitive advantage by being alocally owned financial institution which will contribute to increased marketshare. However, no assurance of market growth can be given.

Themajority of the deposits continue to be CDs, which increased $3,756,000 in thefirst nine months of 2007. At September 30, 2007, the weighted average rate onCDs was 5.09% compared to 4.23% for the nine months ended September 30, 2006.The Company has time deposits maturing within one year of $114,802,000 or 94.6%of total time deposits. Time deposits maturing greater than one year were$6,505,000 or 5.4% of total time deposits. Interest-bearing accounts, otherthan CDs, decreased $262,000 in the first nine months of 2007. Noninterestbearing deposits decreased $291,000 for the nine months ended September 30,2007. The weighted average cost of all deposit accounts during the first ninemonths of 2007 was 3.80% compared to 3.10% for the same period in 2006.

Totalshareholders’ equity decreased $703,000, to $16,207,000 at September 30, 2007,from $16,910,000 at December 31, 2006. This decrease was due to the Company’snet loss of $640,000 for the first nine months of 2007 along with a netincrease in unrealized losses on securities available for sale of $116,000 netof tax.  There was $34,000 in additionalpaid in capital related to stock option compensation according to FASB123R.  Stock options totaling $20,000were exercised during the year and the tax benefit of $13,000 wasrecognized.  The 5% stock dividenddeclared on May 17, 2007 resulted in $14,000 paid for fractional shares.

Asof September 30, 2007 the Bank is categorized as well capitalized under theregulatory framework for prompt corrective action. The total capital torisk-weighted assets ratio was 13.13%. Tier-1 to risk-weighted assets ratio was11.86% and Tier-1 to average asset ratio was 9.60%.

 

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**RESULTS OF OPERATIONS**

Forthe first nine months of 2007, the company’s net loss after tax was $640,000,compared to net income of $1,679,000 for the same period in 2006. The decreasein earnings over the previous year was a result of a substantial increase inthe provision for loan losses, $2,940,000 at September 30, 2007 compared to$435,000 at September 30, 2006 along with a lower loan-to-deposit ratio, 79.9%at September 30, 2007 compared to 89.9% at September 30, 2006, and a decreasein net interest margin and an increase in personnel and other operatingexpenses.  Net interest income before theprovision for loan losses for the first nine months of 2007 was $5,145,000, adecrease of $328,000 from $5,473,000 for the first nine months of 2006. Thedecrease is due to loans representing 74.8% of average interest earning assetsat September 30, 2007, compared to 82.0% at September 30, 2006.  The net interest margin for September 30,2007 was 3.29%, compared to 3.93% at September 30, 2006.

Interestand fee income on loans for the first nine months of 2007 was $9,092,000, anincrease of $527,000 or 6.15% from $8,565,000 for the nine months endedSeptember 30, 2006. The increase in interest and fee income on loans isprimarily due to increased rates. The yield on all loans increased 29 basispoints to 7.77% for the nine months ended September 30, 2007 compared to 7.48%for the nine months ended September 30, 2006. Average loans outstanding atSeptember 30, 2007 were $156,537,000 compared to $153,963,000 at September 30,2006.

Interestincome from securities and short-term funds totaled $1,761,000 for the firstnine months of 2007, an increase of $649,000 over the same period of 2006. Theincrease in 2007 was due to an increase in the average dollar amount ofsecurities and short-term funds outstanding; $52,613,000 at September 30, 2007compared to $33,814,000 at September 30, 2006 and the increase in short termrates. The yield on securities and short-term funds increased to 4.47% atSeptember 30, 2007 compared to 4.37% at September 30, 2006.

Interestexpense totaled $5,708,000 in the first nine months of 2007, compared to $4,204,000for the same period of 2006. The increase in interest expense in 2006 was dueto the growth of deposits and an increase in short term rates. The Company’scost of funds increased to 4.27% at September 30, 2007 compared to 3.49% atSeptember 30, 2006. Total deposits outstanding at September 30, 2007 were$193,918,000 compared to $179,204,000 at September 30, 2006.

TheCompany’s yield on earning assets has increased to 6.94%, for the first ninemonths of 2007 compared to 6.92% for the same period of 2006. The cost ofinterest-bearing funds has followed the same trend, increasing to 4.37% for thefirst nine months of 2007, up from 3.62% for the nine months ended September30, 2006.  The Company’s net interestmargin for the first nine months of 2007 was 3.29% as compared toSeptember 30, 2006 at 3.93%. See Interest Rate Sensitivity for further discussion.

The allowance for loan losses is maintained bymanagement at a level considered adequate to cover probable incurred losses inthe Company’s loan portfolio.  Managementestimates the allowance balance required using past loan loss experience, thenature and volume of the portfolio, information about specific borrowersituations and estimated collateral values, economic conditions, and otherfactors.   The Company provided$2,940,000 for loan losses in the nine months ended September 30, 2007,compared to $435,000 for the same period of 2006.  The substantial increase in the loan lossprovision for the third quarter and nine months ended September 30, 2007relates primarily to a group of loans to borrowers controlled by one guarantorthat totaled approximately $6.7 million in the aggregate.  An extensive review and analysis of the loansand their collateral in order to determine their level of impairment andpossible loss was performed.  Based onthis review the company concluded to increase its allowance for loan lossesthrough an additional provision of approximately $3.0 million. The netcharge-offs for the first nine months of 2007 were $148,000 compared to$271,000 for the same period in 2006. This compares to net charge offs of$847,000 and $83,000 for the years ended December 31, 2006 and 2005.  AtSeptember 30, 2007, the Company had three loans totaling $3,307,000 innonaccrual status.  This compares with December 31, 2006, where there werethree loans totaling $250,000 in nonaccrual. There were 37 loans totaling $9.7million internally classified as substandard or doubtful loans at September 30,2007 compared to 38 loans totaling $7.8 million at September 30, 2006.  At September 30, 2007, the ratio of allowancefor loan losses to total loans was 3.12% compared to 1.22% atDecember 31, 2006.

 

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Totalnoninterest income for the first nine months of 2007 was $1,547,000 compared to$1,741,000 for the same period in 2006. The largest single source ofnoninterest income is service charges on deposit accounts. Service charges ondeposits totaled $669,000 in 2007 compared to $815,000 in 2006. The decrease isdue primarily to lower NSF and overdraft protection fee income realized duringthe period. Mortgage banking income was $493,000 for the nine months endedSeptember 30, 2007 compared to $512,000 for the same period in 2006. For thenine months ended September 30, 2007, the Company originated for subsequentsale, 155 loans for $21,999,000 compared to 146 loans for $22,446,000 for thesame period in 2006. The average loan closed decreased $12,000 to $142,000 from$154,000 in the previous year. Net securities gains or losses reflected a gainof $11,000 in 2007 compared to a gain of $196,000 in 2006. Other servicecharges, commissions and fees were $374,000 as of September 30, 2007 ascompared to $218,000 for the same period in 2006. This includes safe depositbox rent, ATM interchange and surcharges, credit card interchange income, andthe sale of checks to depositors.  The$156,000 increase is primarily due to the fees generated from brokerageservices the company began offering in the second quarter of 2007 totaling$65,000 at September 30, 2007.  ATM feerevenue increased $60,000 and merchant credit card income increased $12,000 forthe period.

Noninterestexpenses were $5,007,000 for the first nine months of 2007 compared with$4,254,000 for the same period of 2006; an increase of $753,000 or 17.7%.  Most of the increase was the result of otheroperating expenses and to some extent increases in salaries and employeebenefits expense. Salaries and employee benefit expense increased $172,000 or7.6% compared to the same period ended 2006 as a result of pay increases anadditional experienced staffing added in key positions.    Other operating expenses increased $568,000in the first nine months of 2007 as compared to the same period in 2006. Most of the individual significant increases came from increases in areas suchas data processing $96,000, marketing $76,000, outside services related tolegal audit accounting and other $66,000, loan expense $47,000, loss recognizedon retirement of the company’s phone system $44,000, loss on sale of ORE$42,000, check 21 charges $36,000, ATM expense $33,000, FDIC insurance $29,000,FF&E expense $14,000, and supplies $14,000.

TheCompany recorded tax expense of $4,000 and a federal and state income taxbenefit of $615,000 for the three and nine months ended September 30, 2007compared to $265,000 and $846,000 expense for the same period in 2006.  The effective tax rate for the three and ninemonths ended 2007 was 6% and 49% compared to 32% and 34% for the same periodsended 2006.  The increased effective taxrate for the nine month period ended September 30, 2007 is due to recognitionof future state income tax benefit and a carryback for federal tax purposes asa result of the loss incurred.  Thedecrease in the effective tax rate for the three month period ended September30, 2007 is the result of the low pretax income and the increase in the Company’saverage tax free securities during the period. Tax free income for the year was $749,000 compared to $456,000 in theprior year.

Theabove discussion compares the financial condition of Southern HeritageBancshares, Inc. (the “Company”) at September 30, 2007, to December 31, 2006,and the results of operations for the nine months ended September 30, 2007 and2006.  Reasons for changes in the resultsof operations for the three month period ended September 30, 2007 as comparedto the comparable period in 2006, except as discussed above, are primarily thesame as those for the year to date results.

 

**LIQUIDITY AND CAPITAL RESOURCES**

Liquidityrefers to the Bank’s ability to fund loan demand, meet deposit customers’withdrawal needs and provide for operating expenses. As summarized in theStatement of Cash Flows, the Bank’s main source of cash flow is from receivingdeposits from its customers, and to a lesser extent, repayment of loanprincipal and interest income on loans and investments. The primary uses ofcash are lending to the Bank’s borrowers, and investing in securities andshort-term interest-earning assets.

In the first nine months of 2007, depositgrowth has exceeded loan growth; however, this is more of a timing issue and isnot expected to continue. Other potential sources of liquidity include the saleof available-for-sale securities from the Bank’s portfolio, the sale of loans,the purchase of federal funds, or repurchase agreements. The Bank currently has$6,445,000 in brokered certificates of deposit, compared to $21,526,000 atDecember 31, 2006.

 

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AtSeptember 30, 2007 and December 31, 2006, the Bank’s risk-based capital ratiosand the minimums to be considered well-capitalized under the Federal ReserveBoard’s prompt corrective action guidelines were as follows:
| ** **                             | ** ** | **September  30, 2007** | ** ** | **Dec. 31, 2006** | ** ** | **Well-capitalized** | ** ** |
|----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|----------------------|------------|
|                                   |       |                    |       |                        |       |                 |       |
| Tier 1 capital to risk-weighted assets |       | 11.86                   | %          | 12.26                       | %          | 6.0                  | %          |
| Total capital to risk-weighted assets  |       | 13.13                   | %          | 13.35                       | %          | 10.0                 | %          |
| Tier 1 leverage ratio                  |       | 9.60                    | %          | 10.82                       | %          | 5.0                  | %          |

 

Asdiscussed above, total shareholders’ equity decreased $703,000, to $16,207,000at September 30, 2007 from $16,910,000 at December 31, 2006. This decrease wasdue to the Bank’s net loss of $640,000 for the first nine months of 2007 alongwith a net increase in unrealized losses on securities available for sale of$116,000, net of tax.  There was $34,000in additional paid in capital related to stock option compensation according toFASB 123R.  Stock options totaling$20,000 were exercised during the year and a tax benefit of $13,000 wasrecognized.  The 5% stock dividenddeclared on May 17, 2007 resulted in $14,000 paid for fractional shares.

Thepayment of dividends by the Company depends to a great extent on the ability ofthe Bank to pay dividends to the Company. The Bank is subject to the TennesseeBanking Act, which provides that the Bank may not declare dividends in anycalendar year that exceeds the total of its net income of that year combinedwith its retained net income of the preceding two years without the approval ofthe Tennessee Department of Financial Institutions. Thereafter, 10% of netprofits must be transferred to capital surplus prior to payment of dividendsuntil capital surplus equals capital stock. The Bank is also subject to theminimum capital requirements of the FDIC which impact the Bank’s ability to paydividends. If the Bank fails to meet these standards, it may not be able to paydividends or to accept additional deposits because of regulatory requirements.

If,in the opinion of the applicable federal bank regulatory authority, adepository institution is engaged in or is about to engage in an unsafe orunsound practice (which, depending on the financial condition of the depositoryinstitution, could include the payment of dividends), such authority mayrequire that such institution cease and desist from such practice. The federalbanking agencies have indicated that paying dividends that deplete a depositoryinstitution’s capital base to an inadequate level would be such an unsafe andunsound banking practice. Moreover, the Federal Reserve Board, the Comptrollerof the Currency and the FDIC have issued policy statements which provide thatbank holding companies and insured depository institutions generally shouldonly pay dividends out of current earnings.

##  

## *ITEM 3:  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK*

 

Like all financial institutions, we are subject tomarket risk from changes in interest rates. Interest rate risk is inherent inthe balance sheet due to the mismatch between the maturities of rate sensitiveassets and rate sensitive liabilities. If rates are rising, and the level ofrate sensitive liabilities exceeds the level of rate sensitive assets, the netinterest margin will be negatively impacted. Conversely, if rates are falling,and the level of rate sensitive liabilities is greater than the level of ratesensitive assets, the impact on the net interest margin will be favorable.Managing interest rate risk is further complicated by the fact that all ratesdo not change at the same pace, in other words, short term rates may be risingwhile longer term rates remain stable. In addition, different types of ratesensitive assets and rate sensitive liabilities react differently to changes inrates.

 

 

 

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To manage interest rate risk, we must take a positionon the expected future trend of interest rates. Rates may rise, fall, or remainthe same. Our asset liability committee develops its view of future rate trendsand strives to manage rate risk within a targeted range by monitoring economicindicators, examining the views of economists and other experts, andunderstanding the current status of our balance sheet. Our annual budgetreflects the anticipated rate environment for the next twelve months. The assetliability committee conducts a quarterly analysis of the rate sensitivityposition and reports its results to our board of directors.

 

The asset liability committeeuses a computer model to analyze the maturities of rate sensitive assets andliabilities. The model measures the “gap” which is defined as the differencebetween the dollar amount of rate sensitive assets repricing during a periodand the volume of rate sensitive liabilities repricing during the same period.Gap is also expressed as the ratio of rate sensitive assets divided by ratesensitive liabilities. If the ratio is greater than “one”, the dollar value ofassets exceeds the dollar value of liabilities, and the balance sheet is “assetsensitive”. Conversely, if the value of liabilities exceeds the value ofassets, the ratio is less than one and the balance sheet is “liabilitysensitive”. Our internal policy requires management to maintain the total gapwithin a range of 0.75 to 1.25.  AtSeptember 30, 2007 we are “liability sensitive” with a ratio of 0.65.

 

The model measures scheduledmaturities in periods of three months, four to twelve months, one to five yearsand over five years. The chart below illustrates our rate sensitive position atSeptember 30, 2007. Management uses the one year gap as the appropriate timeperiod for setting strategy.

 

**INTEREST RATE SENSITIVITY**

Financial institutions aresubject to interest rate risk to the degree that their interest-bearingliabilities (consisting principally of customer deposits) mature or repricemore or less frequently than their interest-earning assets (generallyconsisting of loans and investment securities). The match between the scheduledrepricing and maturities of earning assets and liabilities within defined timeperiods is referred to as “gap” analysis. At September 30, 2007 the cumulativeone-year gap was a negative (or liability sensitive) $59,079,000 or 28.3% ofearning assets compared to a negative gap of $25,298,000 or 12.3% of earningassets at December 31, 2006.

 

One of management’s objectivesin managing the Company’s balance sheet for interest rate sensitivity is toreduce volatility in the net interest margin by matching, as closely aspossible, the timing of the repricing of its interest rate sensitive assetswith interest rate sensitive liabilities. During the first nine months of 2007rates increased once compared to four rate increases in the first nine monthsof 2006. Management believes that interest rates will level off and possiblydecline within the next two years. The Bank’sstrategy of being in a negative one year gap position should result in stableto improving net interest margin as rates decline. The Bank maintained anegative position during the fourth quarter of 2006. This position continuedinto the third quarter of 2007 and contributed to the net interest margindecreasing from 3.93% to 3.29% at September 30, 2007. Many of the Bank’s loansare commercial real estate loans with rates that are tied to New York Prime orthat are fixed for up to three years, and this strategy allows the Bank tomatch longer-term funding with these loans, thus minimizing volatility in thenet interest margin.

 

 

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**Interest Rate Gap Analysis**
| ** **                                             | ** ** | **Reprice’s or Maturing Within** | ** **   |
|--------------------------------------------------------|------------|---------------------------------------|--------------|
| ** **                                             | ** ** | **(Dollars in Thousands)**            | ** **   |
| ** **                                             | ** ** | **0-3  Months**                       | ** **   | **3-12  Months** | ** ** | **Total  1 Year** | ** ** | **1-5  Years** | ** ** | **Over  5 Years** | ** ** | **Total** | ** ** |
| ASSETS                                                 |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
|                                                   |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
| Securities available for  sale, at fair value          |       | $                                     |  753    |   | $ |  — |   | $ |  753 |   | $ |  25,885 |   | $ |  18,606 |   | $ |  45,244 |   |
| Federal funds sold                                     |       | 7,300                                 |         | — |   | 7,300 |   | — |   | — |   | 7,300 |   |
| Mortgage loans held for  sale                          |       | 963                                   |         |   |   | 963 |   |   |   |   |   | 963 |   |
| Loans                                                  |       | 73,473                                |         | 25,247 |   | 98,720 |   | 50,064 |   | 6,182 |   | 154,966 |   |
|                                                   |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
| Total Earning Assets                                   |       | $                                     |  82,489 |   | $ |  25,247 |   | 107,736 |   | $ |  75,949 |   | $ |  24,788 |   | 208,473 |   |
|                                                   |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES                                            |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
|                                                   |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing deposits                              |       | $                                     |  78,331 |   | $ |  83,109 |   | 161,440 |   | $ |  6,505 |   | $ |  — |   | 167,945 |   |
| Subordinated debentures                                |       | 5,155                                 |         |   |   | 5,155 |   |   |   |   |   | 5,155 |   |
| Other borrowings                                       |       | 220                                   |         | — |   | 220 |   | — |   | — |   | 220 |   |
| Total interest-bearing  liabilities                    |       | $                                     |  83,706 |   | $ |  83,109 |   | 166,815 |   | $ |  6,505 |   | $ |  — |   | 173,320 |   |
|                                                   |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
| Asset (liability) GAP                                  |       | (1,217                                | )            | (57,862 | ) | (59,079 | ) | 69,444 |   | 24,788 |   | 35,153 |   |
|                                                   |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
| Cumulative asset  (liability) GAP                      |       | (1,217                                | )            | (59,079 | ) | (59,079 | ) | 10,365 |   | 35,153 |   | 35,153 |   |
|                                                   |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
| Cumulative as a percentage  of interest-earning assets |       | (0.6                                  | )%           | (28.3 | )% | (28.3 | )% | 5.0 | % | 16.9 | % | 16.9 | % |
|                                                   |       |                                  |         |   |   |   |   |   |   |   |   |   |   |
|                                                        |            |                                       |              |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**OFF-BALANCE SHEET ARRANGEMENTS**

We are a party to financialinstruments with off-balance sheet risk in the normal course of business tomeet the financing needs of its consumers.  At September 30, 2007, we hadunfunded loan commitments outstanding of $41.9 million and standby letters ofcredit of $3.2 million.  These financial instruments include commitmentsto extend credit and standby letters of credit.  Those instrumentsinvolve, to varying degrees, elements of credit risk in excess of the amountrecognized in the balance sheet.  The contract or notional amounts ofthose instruments reflect the extent of our involvement in those particularfinancial instruments.  We use the same credit policies in makingcommitments and conditional obligations as it does for on-balance sheetinstruments.

 

Because these commitmentsgenerally have fixed expiration dates and many will expire without being drawnupon, the total commitment level does not necessarily represent future cashrequirements.  If needed, we can liquidate Federal funds sold orsecurities available for sale or borrow and purchase Federal funds from otherfinancial institutions where we have available federal funds lines totaling $14million.

 

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* *

## *ITEM 4:  CONTROLS AND PROCEDURES*

 

**DISCLOSURE CONTROLS**

The Company maintainsdisclosure controls and procedures, as defined in Rule 13a-15(a) promulgatedunder the Securities Exchange Act of 1934 (the “Exchange Act”), that aredesigned to ensure that information required to be disclosed by the Company inthe reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported within the time period specified in the SEC’srules and forms and that such information is accumulated and communicated tothe management of the Company, including its ChiefExecutive Officer and Chief Financial Officer (“Management”), as appropriate,to allow timely decisions regarding required disclosure.

 

Under the supervision andwith the participation of Management, the Company evaluated the effectivenessof the design and operation of its disclosure controls and procedures as of theend of the period covered by this report. Based on the evaluation of thesedisclosure controls and procedures, the Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures were effective, subject to the effectiveness of theCompany’s internal control over financial reporting.

 

**INTERNAL CONTROLS**

Management is responsiblefor establishing and maintaining adequate internal control over financialreporting.  The Company’s internal control system wasdesigned to provide reasonable assurance to Management and the board ofdirectors regarding the fair and reliable preparation and presentation of theconsolidated financial statements.

 

Crowe Chizek and Company LLC(“Crowe”) is the independent registered public accounting firm responsible forauditing the Company’s consolidated financial statements.  In connection with Crowe’s audit of theCompany’s 2006 consolidated financial statements, Crowe submitted a draftreport to Management and the Audit Committee on April 12, 2007 stating that acombination of control deficiencies and financial reporting errors amounted toa material weakness in internal controls over financialreporting.  Crowe submitted its finalreport on April 20, 2007 (the “Report”). Management has thoroughly reviewed the draft and final reports and itsfindings and does not concur that a material weakness exists.  Nonetheless, Management has agreed to reviewthe matters presented by Crowe in the Report and to respond to the deficienciesraised in the Report.

 

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**PART II - OTHER INFORMATION**

**ITEM 1. LEGAL PROCEEDINGS**

There are no material pendinglegal proceedings to which the Company is a party of which any of theirproperty is the subject.

 

**ITEM 1A. RISK FACTORS**

For a discussion of those “Risk Factors” affecting the Company, you should carefullyconsider the “Risk Factors” discussed in Part II, under “Item 1A Risk Factors” containedin our Quarterly Report on Form 10-Q for the quarter ended June 30, 2007, whichis herein incorporated by reference.  There have been no material changesfrom those risk factors previously disclosed in such Quarterly Report.

 

**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

 

(a)        None

 

 

(b)         Not applicable.

 

 

(c)         No repurchases for our securities weremade during the quarter ended September 30, 2007.

**ITEM3:  DEFAULTS UPON SENIOR SECURITIES**

(a)                                  None

(b)                                 None

**ITEM4:  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

(a)**          **None

(b)           None

 

 

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**ITEM 5:  OTHER INFORMATION**

(a)                                  None

(b)                                 None

**ITEM 6:  EXHIBITS**
| 2.1*   |   | Articles of Share Exchange  of Southern Heritage Bank and Southern Heritage Bancshares, Inc. as filed on August 31, 2004. |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------|
| 2.2*   |   | Plan of Share Exchange dated  as of August 23, 2004 between Southern Heritage Bank and Southern Heritage Bancshares,  Inc.          |
| 3.1*   |   | Charter of Southern Heritage Bancshares, Inc.                                                                                       |
| 3.2*   |   | By-laws of Southern Heritage Bancshares, Inc.                                                                                       |
|   |   |                                                                                                                                |
| 31.1   |   | Rule 13a-14(a)/15d-15(e) Certification of the President.                                                                            |
| 31.2   |   | Rule 13a-14(a)/15d-15(e) Certification of the Chief Financial Officer.                                                              |
|   |   |                                                                                                                                |
| 32.1   |   | Section 1350 Certification of the President.                                                                                        |
| 32.2   |   | Section 1350 Certification of the Chief Financial Officer.                                                                          |

Previously filedas an Exhibit to Southern Heritage Bancshares, Inc.’s Form 8-Kas filed with the Securities Exchange Commission on August 31, 2004 andincorporated by reference herein.

 

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**SOUTHERN HERITAGE BANCSHARES, INC.**

**FORM 10-Q**

Quarter ended September 30, 2007

**SIGNATURES**

In accordance with therequirements of the Exchange Act, the Registrant caused this report to besigned on its behalf by the undersigned thereunto duly authorized.

 
|              |   | Southern Heritage Bancshares, Inc. |                    |
|-------------------|--------|------------------------------------|-------------------------|
|              |   | (Registrant)                       |                    |
|              |   |                               |                    |
| November 14, 2007 |   |                               | /s/ J. Lee Stewart      |   |
| (Date)            |   | J. Lee Stewart                     |                    |
|              |   | Chief Executive Officer            |                    |
|              |   |                               |                    |
| November 14, 2007 |   |                               | /s/ Steven W. Ledbetter |   |
| (Date)            |   | Steven W. Ledbetter,               |                    |
|              |   | Chief Financial Officer            |                    |

 

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