UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549





FORM
10-Q


(Mark
One)





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





For
the quarterly period ended September 30, 2010





OR





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





Commission
File Number 0-18832





First
Financial Service Corporation


(Exact
Name of Registrant as specified in its charter)





Kentucky
            61-1168311(State
      or other jurisdiction
            (IRS
      Employer Identification No.)of
      incorporation or organization)2323
      Ring Road
            (270)
      765-2131Elizabethown,
      Kentucky 42701
            (Registrant's
      telephone number,(Address
      of principal executive offices)
            including
      area code)(Zip
      Code)




(270)
765-2131


(Registrant's
telephone number, including area code)





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.


Yes xNo o





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).


Yes oNo o





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definition of “accelerated filer”, “large accelerated
filer” and “smaller reporting company” in Rule 12b-2 of the Exchange
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 a check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act).


Yes oNo x





Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date.





Class
            Outstanding
      as of October 31, 2010Common
      Stock
            4,726,168shares










FIRST
FINANCIAL SERVICE CORPORATION


FORM
10-Q


TABLE
OF CONTENTS





PART I–FINANCIAL
      INFORMATIONPreliminary
      Note Regarding Forward-Looking Statements
            3Item
      1.
            Consolidated
      Financial Statements and Notes to ConsolidatedFinancial
      Statements
            4Item
      2.
            Management's
      Discussion and Analysis of FinancialCondition
      and Results of Operations
            24Item
      3.
            Quantitative
      and Qualitative Disclosures about Market Risk
            40Item
      4.
            Controls
      and Procedures
            42PART II– OTHER
      INFORMATIONItem
      1.
            Legal
      Proceedings
            42Item
      1A.
            Risk
      Factors
            42Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            43Item
      3.
            Defaults
      upon Senior Securities
            43Item
      4.
            Reserved
            43Item
      5.
            Other
      Information
            43Item
      6.
            Exhibits
            43SIGNATURES
            44





2




PRELIMINARY
NOTE REGARDING


FORWARD-LOOKING
STATEMENTS





Statements
in this report that are not statements of historical fact are forward-looking
statements. First Financial Service Corporation (the “Corporation”) may make
forward-looking statements in future filings with the Securities and Exchange
Commission (“SEC”), in press releases, and in oral and written statements made
by or with the approval of the Corporation.  Forward-looking
statements include, but are not limited to: (1) projections of revenues, income
or loss, earnings or loss per share, capital structure and other financial
items; (2) plans and objectives of the Corporation or its management or Board of
Directors; (3) statements regarding future events, actions or economic
performance; and (4) statements of assumptions underlying such
statements.  Words such as “estimate,” “strategy,” “believes,”
“anticipates,” “expects,” “intends,” “plans,” “targeted,” and similar
expressions are intended to identify forward-looking statements, but are not the
exclusive means of identifying such statements.





Various
risks and uncertainties may cause actual results to differ materially from those
indicated by our forward-looking statements.  In addition to those
risks described under “Item 1A Risk Factors,” of this report and our Annual
Report on Form 10-K, the following factors could cause such differences: changes
in general economic conditions and economic conditions in Kentucky and the
markets we serve, any of which may affect, among other things, our level of
non-performing assets, charge-offs, and provision for loan loss expense; changes
in interest rates that may reduce interest margins and impact funding sources;
changes in market rates and prices which may adversely impact the value of
financial products including securities, loans and deposits; changes in tax
laws, rules and regulations; various monetary and fiscal policies and
regulations, including those determined by the Federal Reserve Board, the
Federal Deposit Insurance Corporation (“FDIC”) and the Kentucky Department of
Financial Institutions (“KDFI”); competition with other local and regional
commercial banks, savings banks, credit unions and other non-bank financial
institutions; our ability to grow core businesses; our ability to develop and
introduce new banking-related products, services and enhancements and gain
market acceptance of such products; and management’s ability to manage these and
other risks.





Our
forward-looking statements speak only as of the date on which they are made, and
we undertake no obligation to update any forward-looking statement to reflect
events or circumstances after the date of the statement to reflect the
occurrence of unanticipated events.





3




Item
      1.
              FIRST
      FINANCIAL SERVICE CORPORATIONConsolidated
      Balance Sheets(Unaudited)
  September
      30,
                
                
                December
      31,(Dollars
      in thousands, except per share data)
                
                2010
                
                
                2009ASSETS:Cash
      and due from banks
                
                $
                12,591
                
                
                $
                21,253Interest
      bearing deposits
                
                
                76,407
                
                
                
                77,280Total
      cash and cash equivalents
                
                
                88,998
                
                
                
                98,533Securities
      available-for-sale
                
                
                164,750
                
                
                
                45,764Securities
      held-to-maturity, fair value of $131 Sept 2010 and $1,176 Dec
      2009
                
                
                128
                
                
                
                1,167Total
      securities
                
                
                164,878
                
                
                
                46,931Loans
      held for sale
                
                
                13,213
                
                
                
                8,183Loans,
      net of unearned fees
                
                
                920,095
                
                
                
                994,926Allowance
      for loan losses
                
                
                (20,091
                )
                
                
                (17,719
                )Net
      loans
                
                
                913,217
                
                
                
                985,390Federal
      Home Loan Bank stock
                
                
                5,015
                
                
                
                8,515Cash
      surrender value of life insurance
                
                
                9,266
                
                
                
                9,008Premises
      and equipment, net
                
                
                32,317
                
                
                
                31,965Real
      estate owned:Acquired
      through foreclosure
                
                
                12,781
                
                
                
                8,428Held
      for development
                
                
                45
                
                
                
                45Other
      repossessed assets
                
                
                48
                
                
                
                103Core
      deposit intangible
                
                
                1,071
                
                
                
                1,300Accrued
      interest receivable
                
                
                6,248
                
                
                
                5,658Accrued
      income taxes
                
                
                3,754
                
                
                
                -Deferred
      income taxes
                
                
                3,377
                
                
                
                4,515Prepaid
      FDIC premium
                
                
                5,163
                
                
                
                7,022Other
      assets
                
                
                2,651
                
                
                
                2,091TOTAL
      ASSETS
                
                $
                1,248,829
                
                
                $
                1,209,504LIABILITIES
      AND STOCKHOLDERS' EQUITYLIABILITIES:Deposits:Non-interest
      bearing
                
                $
                70,288
                
                
                $
                63,950Interest
      bearing
                
                
                1,018,438
                
                
                
                985,865Total
      deposits
                
                
                1,088,726
                
                
                
                1,049,815Short-term
      borrowings
                
                
                345
                
                
                
                1,500Advances
      from Federal Home Loan Bank
                
                
                52,564
                
                
                
                52,745Subordinated
      debentures
                
                
                18,000
                
                
                
                18,000Accrued
      interest payable
                
                
                246
                
                
                
                360Accounts
      payable and other liabilities
                
                
                3,956
                
                
                
                1,952TOTAL
      LIABILITIES
                
                
                1,163,837
                
                
                
                1,124,372Commitments
      and contingent liabilities
                
                
                -
                
                
                
                -STOCKHOLDERS'
      EQUITY:Serial
      preferred stock, $1 par value per share;authorized
      5,000,000 shares; issued and outstanding, 20,000 shares with a liquidation
      preference of $20,000
                
                
                19,822
                
                
                
                19,781Common
      stock, $1 par value per share;authorized
      10,000,000 shares; issued and outstanding, 4,726,075 shares Sept 2010, and
      4,709,839 shares Dec 2009
                
                
                4,726
                
                
                
                4,710Additional
      paid-in capital
                
                
                35,171
                
                
                
                34,984Retained
      earnings
                
                
                24,128
                
                
                
                26,720Accumulated
      other comprehensive income/(loss)
                
                
                1,145
                
                
                
                (1,063
                )TOTAL
      STOCKHOLDERS' EQUITY
                
                
                84,992
                
                
                
                85,132TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                
                $
                1,248,829
                
                
                $
                1,209,504




See
      notes to the unaudited consolidated financial
  statements.




4




FIRST
      FINANCIAL SERVICE CORPORATIONConsolidated
      Statements of Income(Unaudited)




Three
      Months Ended
                
                
                Nine
      Months EndedSeptember
      30,
                
                
                September
      30,(Dollars
      in thousands, except per share data)
                
                2010
                
                
                2009
                
                
                2010
                
                
                2009Interest
      and Dividend Income:Loans,
      including fees
                
                $
                13,543
                
                
                $
                14,410
                
                
                $
                41,857
                
                
                $
                42,509Taxable
      securities
                
                
                1,117
                
                
                
                312
                
                
                
                2,488
                
                
                
                925Tax
      exempt securities
                
                
                255
                
                
                
                137
                
                
                
                628
                
                
                
                361Total
      interest income
                
                
                14,915
                
                
                
                14,859
                
                
                
                44,973
                
                
                
                43,795Interest
      Expense:Deposits
                
                
                4,883
                
                
                
                4,513
                
                
                
                14,642
                
                
                
                13,359Short-term
      borrowings
                
                
                6
                
                
                
                27
                
                
                
                38
                
                
                
                117Federal
      Home Loan Bank advances
                
                
                599
                
                
                
                601
                
                
                
                1,788
                
                
                
                1,798Subordinated
      debentures
                
                
                331
                
                
                
                331
                
                
                
                989
                
                
                
                989Total
      interest expense
                
                
                5,819
                
                
                
                5,472
                
                
                
                17,457
                
                
                
                16,263Net
      interest income
                
                
                9,096
                
                
                
                9,387
                
                
                
                27,516
                
                
                
                27,532Provision
      for loan losses
                
                
                6,327
                
                
                
                2,482
                
                
                
                11,353
                
                
                
                6,441Net
      interest income after provision for loan losses
                
                
                2,769
                
                
                
                6,905
                
                
                
                16,163
                
                
                
                21,091Non-interest
      Income:Customer
      service fees on deposit accounts
                
                
                1,671
                
                
                
                1,750
                
                
                
                4,935
                
                
                
                4,872Gain
      on sale of mortgage loans
                
                
                513
                
                
                
                300
                
                
                
                1,227
                
                
                
                832Gain/(loss)
      on sale of investments
                
                
                7
                
                
                
                -
                
                
                
                (16
                )
                
                
                -Other
      than temporary impairment loss:Total
      other-than-temporary impairment losses
                
                
                (649
                )
                
                
                (304
                )
                
                
                (832
                )
                
                
                (918
                )Portion
      of loss recognized in other comprehensive income(before
    taxes)
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (215
                )Net
      impairment losses recognized in earnings
                
                
                (649
                )
                
                
                (304
                )
                
                
                (832
                )
                
                
                (703
                )Loss
      on sale and write downs of real estate acquired through
      foreclosure
                
                
                (374
                )
                
                
                (305
                )
                
                
                (838
                )
                
                
                (555
                )Brokerage
      commissions
                
                
                109
                
                
                
                89
                
                
                
                309
                
                
                
                281Other
      income
                
                
                703
                
                
                
                365
                
                
                
                1,514
                
                
                
                1,263Total
      non-interest income
                
                
                1,980
                
                
                
                1,895
                
                
                
                6,299
                
                
                
                5,990Non-interest
      Expense:Employee
      compensation and benefits
                
                
                4,176
                
                
                
                4,042
                
                
                
                12,171
                
                
                
                12,193Office
      occupancy expense and equipment
                
                
                779
                
                
                
                832
                
                
                
                2,351
                
                
                
                2,488Marketing
      and advertising
                
                
                225
                
                
                
                225
                
                
                
                675
                
                
                
                735Outside
      services and data processing
                
                
                622
                
                
                
                793
                
                
                
                2,020
                
                
                
                2,381Bank
      franchise tax
                
                
                566
                
                
                
                257
                
                
                
                1,482
                
                
                
                778FDIC
      insurance premiums
                
                
                615
                
                
                
                414
                
                
                
                1,969
                
                
                
                1,381Amortization
      of core deposit intangible
                
                
                77
                
                
                
                100
                
                
                
                229
                
                
                
                302Real
      estate acquired through foreclosure expense
                
                
                302
                
                
                
                124
                
                
                
                916
                
                
                
                366Other
      expense
                
                
                1,352
                
                
                
                1,241
                
                
                
                3,809
                
                
                
                3,632Total
      non-interest expense
                
                
                8,714
                
                
                
                8,028
                
                
                
                25,622
                
                
                
                24,256Income/(loss)
      before income taxes
                
                
                (3,965
                )
                
                
                772
                
                
                
                (3,160
                )
                
                
                2,825Income
      taxes/(benefits)
                
                
                (1,472
                )
                
                
                196
                
                
                
                (1,359
                )
                
                
                773Net
      Income/(loss)
                
                
                (2,493
                )
                
                
                576
                
                
                
                (1,801
                )
                
                
                2,052Less:Dividends
      on preferred stock
                
                
                (250
                )
                
                
                (250
                )
                
                
                (750
                )
                
                
                (730
                )Accretion
      on preferred stock
                
                
                (14
                )
                
                
                (14
                )
                
                
                (41
                )
                
                
                (39
                )Net
      income/(loss) available to common shareholders
                
                $
                (2,757
                )
                
                $
                312
                
                
                $
                (2,592
                )
                
                $
                1,283Shares
      applicable to basic income per common share
                
                
                4,724,043
                
                
                
                4,704,289
                
                
                
                4,719,513
                
                
                
                4,689,917Basic
      income/(loss) per common share
                
                $
                (0.58
                )
                
                $
                0.07
                
                
                $
                (0.55
                )
                
                $
                0.27Shares
      applicable to diluted income per common share
                
                
                4,724,043
                
                
                
                4,734,037
                
                
                
                4,719,513
                
                
                
                4,703,432Diluted
      income/(loss) per common share
                
                $
                (0.58
                )
                
                $
                0.07
                
                
                $
                (0.55
                )
                
                $
                0.27Cash
      dividends declared per common share
                
                $
                -
                
                
                $
                0.05
                
                
                $
                -
                
                
                $
                0.43




See
notes to the unaudited consolidated financial statements.
  5




FIRST
      FINANCIAL SERVICE CORPORATIONConsolidated
      Statements of Comprehensive Income/(Loss)(Unaudited)




Three
      Months Ended
              
              
              Nine
      Months EndedSeptember
      30,
              
              
              September
      30,(Dollars
      in thousands)
              
              2010
              
              
              2009
              
              
              2010
              
              
              2009Net
      Income/(Loss)
              
              $
              (2,493
              )
              
              $
              576
              
              
              $
              (1,801
              )
              
              $
              2,052Other
      comprehensive income (loss):Change
      in unrealized gain (loss) on securities available-for-sale
              
              
              1,103
              
              
              
              1,128
              
              
              
              2,551
              
              
              
              1,401Change
      in unrealized gain (loss) on securities available-for-sale for which a
      portion of other-than-temporary impairment has been recognized into
      earnings
              
              
              (6
              )
              
              
              (213
              )
              
              
              (53
              )
              
              
              101Reclassification
      of realized amount on securities available-for-sale losses
      (gains)
              
              
              641
              
              
              
              304
              
              
              
              798
              
              
              
              679Non-credit
      component of other-than-temporary impairment on held-to-maturity
      securities
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              (215
              )Reclassification
      of unrealized loss on held-to-maturity security recognized in
      income
              
              
              1
              
              
              
              -
              
              
              
              50
              
              
              
              24Accretion
      (amortization) of non-credit component of other-than- temorary impairment
      on held-to-maturity securities
              
              
              -
              
              
              
              3
              
              
              
              (1
              )
              
              
              5Net
      unrealized gain (loss) recognized in comprehensive income
              
              
              1,739
              
              
              
              1,222
              
              
              
              3,345
              
              
              
              1,995Tax
      effect
              
              
              (591
              )
              
              
              (415
              )
              
              
              (1,137
              )
              
              
              (678
              )Total
      other comphrehensive income
              
              
              1,148
              
              
              
              807
              
              
              
              2,208
              
              
              
              1,317Comprehensive
      Income/(Loss)
              
              $
              (1,345
              )
              
              $
              1,383
              
              
              $
              407
              
              
              $
              3,369
  The
following is a summary of the accumulated other comprehensive income balances,
net of tax:
  Balance
      at 12/31/2009
                
                
                Current
      Period Change
                
                
                Balance
      at 9/30/2010Unrealized
      gains (losses) on securities available-for-sale
                
                $
                (925
                )
                
                $
                2,176
                
                
                $
                1,251Unrealized
      gains (losses) on held-to-maturity securities for
      which   OTTI has been recorded, net of
      accretion
                
                
                (138
                )
                
                
                32
                
                
                
                (106
                )Total
                
                $
                (1,063
                )
                
                $
                2,208
                
                
                $
                1,145
 See
notes to the unaudited consolidated financial statements.
  6




FIRST
      FINANCIAL SERVICE CORPORATIONConsolidated
      Statements of Changes in Stockholders' EquityNine
      Months Ended September 30, 2010(Dollars
      In Thousands, Except Per Share Amounts)(Unaudited)
  Shares
              
              
              Amount
              
              
              Additional
      Paid-in
              
              
              Retained
              
              
              Accumulated
      Other Comprehensive (Loss), Net ofPreferred
              
              
              Common
              
              
              Preferred
              
              
              Common
              
              
              Capital
              
              
              Earnings
              
              
              Tax
              
              
              TotalBalance,
      January 1, 2010
              
              
              20,000
              
              
              
              4,710
              
              
              $
              19,781
              
              
              $
              4,710
              
              
              $
              34,984
              
              
              $
              26,720
              
              
              $
              (1,063
              )
              
              $
              85,132Net
      loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (1,801
              )
              
              
              
              
              
              
              (1,801
              )Shares
      issued under dividend reinvestment program
              
              
              
              
              
              
              2
              
              
              
              
              
              
              
              2
              
              
              
              14
              
              
              
              
              
              
              
              
              
              
              
              16Stock
      issued for employee benefit plans
              
              
              
              
              
              
              14
              
              
              
              
              
              
              
              14
              
              
              
              102
              
              
              
              
              
              
              
              
              
              
              
              116Stock-based
      compensation expense
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              71
              
              
              
              
              
              
              
              
              
              
              
              71Net
      change in unrealized gains (losses) on securities available-for-sale, net
      of tax
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,695
              
              
              
              1,695Change
      in unrealized gains (losses) on held-to-maturity  securities for
      which an other-than-temporary impairment charge has been recorded, net of
      tax
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              32
              
              
              
              32Change
      in unrealized gains (losses) on securities available-for-sale for which a
      portion of an other-than-temporary impairment charge has been recognized
      into earnings, net of reclassification and taxes
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              481
              
              
              
              481Dividends
      on preferred stock
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (750
              )
              
              
              
              
              
              
              (750
              )Accretion
      of preferred stock discount
              
              
              -
              
              
              
              -
              
              
              
              41
              
              
              
              -
              
              
              
              -
              
              
              
              (41
              )
              
              
              -
              
              
              
              -Balance,
      September 30, 2010
              
              
              20,000
              
              
              
              4,726
              
              
              $
              19,822
              
              
              $
              4,726
              
              
              $
              35,171
              
              
              $
              24,128
              
              
              $
              1,145
              
              
              $
              84,992
 
 See
notes to the unaudited consolidated financial statements.
 
 7
 FIRST
      FINANCIAL SERVICE CORPORATIONConsolidated
      Statements of Cash Flows(Dollars
      In Thousands)(Unaudited)
 
 Nine
      Months EndedSeptember
      30,2010
                
                
                2009Operating
      Activities:Net
      income/(loss)
                
                $
                (1,801
                )
                
                $
                2,052Adjustments
      to reconcile net income / (loss) to net cash provided by operating
      activities:Provision
      for loan losses
                
                
                11,353
                
                
                
                6,441Depreciation
      on premises and equipment
                
                
                1,320
                
                
                
                1,264Core
      deposit intangible amortization
                
                
                229
                
                
                
                302Net
      amortization (accretion) available-for-sale
                
                
                (1,554
                )
                
                
                131Net
      amortization (accretion) held-to-maturity
                
                
                -
                
                
                
                8Impairment
      loss on securities available-for-sale
                
                
                782
                
                
                
                679Impairment
      loss on securities held-to-maturity
                
                
                50
                
                
                
                24Gain
      on sale of investments available-for-sale
                
                
                (7
                )
                
                
                -Loss
      on sale of investments available-for-sale
                
                
                23
                
                
                
                -Gain
      on sale of mortgage loans
                
                
                (1,227
                )
                
                
                (832
                )Origination
      of loans held for sale
                
                
                (96,445
                )
                
                
                (101,364
                )Proceeds
      on sale of loans held for sale
                
                
                92,642
                
                
                
                104,034Stock-based
      compensation expense
                
                
                71
                
                
                
                78Prepaid
      FDIC premium
                
                
                1,859
                
                
                
                -Changes
      in:Cash
      surrender value of life insurance
                
                
                (258
                )
                
                
                (269
                )Interest
      receivable
                
                
                (590
                )
                
                
                (685
                )Other
      assets
                
                
                (560
                )
                
                
                (931
                )Interest
      payable
                
                
                (114
                )
                
                
                52Accrued
      income tax
                
                
                (3,754
                )
                
                
                (1,013
                )Accounts
      payable and other liabilities
                
                
                2,004
                
                
                
                787Net
      cash from operating activities
                
                
                4,023
                
                
                
                10,758Investing
      Activities:Sales
      of securities available-for-sale
                
                
                665
                
                
                
                -Purchases
      of securities available-for-sale
                
                
                (179,022
                )
                
                
                (19,565
                )Maturities
      of securities available-for-sale
                
                
                63,424
                
                
                
                1,592Maturities
      of securities held-to-maturity
                
                
                1,038
                
                
                
                5,434Net
      change in loans
                
                
                61,552
                
                
                
                (82,728
                )Redemption
      of Federal Home Loan Bank stock
                
                
                3,500
                
                
                
                -Net
      purchases of premises and equipment
                
                
                (1,672
                )
                
                
                (3,541
                )Net
      cash from investing activities
                
                
                (50,515
                )
                
                
                (98,808
                )Financing
      ActivitiesNet
      change in deposits
                
                
                38,911
                
                
                
                162,319Change
      in short-term borrowings
                
                
                (1,155
                )
                
                
                (92,669
                )Repayments
      to Federal Home Loan Bank
                
                
                (181
                )
                
                
                (170
                )Issuance
      of preferred stock, net
                
                
                -
                
                
                
                20,000Issuance
      of common stock under dividend reinvestment program
                
                
                16
                
                
                
                3Issuance
      of common stock for stock options exercised
                
                
                -
                
                
                
                101Issuance
      of common stock for employee benefit plans
                
                
                116
                
                
                
                407Dividends
      paid on common stock
                
                
                -
                
                
                
                (2,015
                )Dividends
      paid on preferred stock
                
                
                (750
                )
                
                
                (730
                )Net
      cash from financing activities
                
                
                36,957
                
                
                
                87,246(Decrease)
      Increase in cash and cash equivalents
                
                
                (9,535
                )
                
                
                (804
                )Cash
      and cash equivalents, beginning of period
                
                
                98,533
                
                
                
                20,905Cash
      and cash equivalents, end of period
                
                $
                88,998
                
                
                $
                20,101Supplemental
      noncash disclosures:Transfers
      from loans to real estate owned
                
                $
                10,434
                
                
                $
                6,652
 
 See
notes to the unaudited consolidated financial statements.
  8




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





1.
            BASIS
      OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
    POLICIES





Basis of
Presentation – The accompanying unaudited consolidated financial
statements include the accounts of First Financial Service Corporation and its
wholly owned subsidiary, First Federal Savings Bank.  First Federal
Savings Bank has three wholly owned subsidiaries, First Service Corporation of
Elizabethtown, Heritage Properties, LLC and First Federal Office Park,
LLC.  Unless the text clearly suggests otherwise, references to "us,"
"we," or "our" include First Financial Service Corporation and its direct and
indirect wholly-owned subsidiaries.  All significant intercompany
transactions and balances have been eliminated in consolidation.





The
accompanying unaudited consolidated financial statements have been prepared in
accordance with U.S. generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Rule 10-01 of
Regulation S-X.  Accordingly, they do not include all of the
information and footnotes required by U.S. generally accepted accounting
principles for complete financial statements.  In the opinion of
management, all adjustments (consisting of normal recurring accruals) considered
necessary for a fair presentation have been included.  Operating
results for the three and nine month periods ending September 30, 2010 are not
necessarily indicative of the results that may occur for the year ending
December 31, 2010.  For further information, refer to the consolidated
financial statements and footnotes thereto included in the Corporation’s annual
report on Form 10-K for the period ended December 31, 2009.





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





Adoption of New
Accounting Standards– FASB ASC 860, Transfers and Servicing, was
issued in June 2009.  This statement amends and removes the concept of
a qualifying special-purpose entity and limits the circumstances in which a
financial asset, or portion of a financial asset, should be derecognized when
the transferor has not transferred the entire financial asset to an entity that
is not consolidated with the transferor in the financial statements being
presented and/or when the transferor has continuing involvement with the
transferred financial asset. The new standard became effective for us on
January 1, 2010 and did not have a material impact.





FASB ASC
810,Consolidations,
was also issued in June 2009 and amends tests for variable interest entities to
determine whether a variable interest entity must be consolidated. This standard
requires an entity to perform an analysis to determine whether an entity’s
variable interest or interests give it a controlling financial interest in a
variable interest entity. This statement requires ongoing reassessments of
whether an entity is the primary beneficiary of a variable interest entity and
enhanced disclosures that provide more transparent information about an entity’s
involvement with a variable interest entity. The new standard became effective
for us on January 1, 2010 and did not have a material impact.





Newly
Issued But Not Yet Effective Accounting Standards–FASB ASU 2010-20, Disclosures about the Credit Quality
of Financing Receivables and the Allowance for Credit Losses, was issued
in July 2010.  The new disclosure guidance will significantly expand the
existing requirements and will lead to greater transparency into a company’s
exposure to credit losses from lending arrangements.  The extensive new
disclosures of information as of the end of a reporting period will become
effective for both interim and annual reporting periods ending after December
15, 2010.  Specific items regarding activity that occurred before the
issuance of the ASU, such as the allowance roll-forward and modification
disclosures, will be required for periods beginning after December 15,
2010.  The Company is currently assessing the impact that ASU 2010-20 will
have on its consolidated financial statements.





9




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





2.
            SECURITIES





The
amortized cost basis and fair values of securities are as follows:





(Dollars
      in thousands)
              
              Amortized
      Cost
              
              
              Gross
      Unrealized Gains
              
              
              Gross
      Unrealized Losses
              
              
              Fair ValueSecurities
      available-for-sale:September
      30, 2010:U.S.
      Treasury and agencies
              
              $
              80,859
              
              
              $
              408
              
              
              $
              (15
              )
              
              $
              81,252Government-sponsored
      mortgage-backed residential
              
              
              57,853
              
              
              
              1,112
              
              
              
              (56
              )
              
              
              58,909Equity
              
              
              309
              
              
              
              8
              
              
              
              (5
              )
              
              
              312State
      and municipal
              
              
              22,613
              
              
              
              1,627
              
              
              
              (24
              )
              
              
              24,216Trust
      preferred securities
              
              
              1,265
              
              
              
              -
              
              
              
              (1,204
              )
              
              
              61Total
              
              $
              162,899
              
              
              $
              3,155
              
              
              $
              (1,304
              )
              
              $
              164,750
  December
      31, 2009:U.S.
      Treasury and agencies
                
                $
                20,000
                
                
                $
                80
                
                
                $
                -
                
                
                $
                20,080Government-sponsored
      mortgage-backed residential
                
                
                9,632
                
                
                
                171
                
                
                
                (51
                )
                
                
                9,752Equity
                
                
                933
                
                
                
                60
                
                
                
                (3
                )
                
                
                990State
      and municipal
                
                
                14,604
                
                
                
                399
                
                
                
                (110
                )
                
                
                14,893Trust
      preferred securities
                
                
                1,983
                
                
                
                -
                
                
                
                (1,934
                )
                
                
                49Total
                
                $
                47,152
                
                
                $
                710
                
                
                $
                (2,098
                )
                
                $
                45,764
  Amortized
      Cost
                
                
                Gross
      Unrecognized Gains
                
                
                Gross
      Unrecognized Losses
                
                
                Fair ValueSecurities
      held-to-maturity:September
      30, 2010:Government-sponsored
      mortgage-backed residential
                
                $
                107
                
                
                $
                3
                
                
                $
                -
                
                
                $
                110Trust
      preferred securities
                
                
                21
                
                
                
                -
                
                
                
                -
                
                
                
                21Total
                
                $
                128
                
                
                $
                3
                
                
                $
                -
                
                
                $
                131December
      31, 2009:Government-sponsored
      mortgage-backed residential
                
                $
                902
                
                
                $
                6
                
                
                $
                -
                
                
                $
                908State
      and municipal
                
                
                245
                
                
                
                3
                
                
                
                -
                
                
                
                248Trust
      preferred securities
                
                
                20
                
                
                
                -
                
                
                
                -
                
                
                
                20Total
                
                $
                1,167
                
                
                $
                9
                
                
                $
                -
                
                
                $
                1,176
  10




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





2.
            SECURITIES
      – (Continued)





The
amortized cost and fair value of securities at September 30, 2010, by
contractual maturity, are shown below.  Securities not due at a single
maturity date, primarily mortgage-backed and equity securities, are shown
separately.





Available
      for Sale
              
              
              Held-to-MaturityAmortized
              
              
              Fair
              
              
              Amortized
              
              
              Fair(Dollars
      in thousands)
              
              Cost
              
              
              Value
              
              
              Cost
              
              
              ValueDue
      in one year or less
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              $
              -Due
      after one year through five years
              
              
              10,514
              
              
              
              10,588
              
              
              
              -
              
              
              
              -Due
      after five years through ten years
              
              
              41,894
              
              
              
              42,159
              
              
              
              -
              
              
              
              -Due
      after ten years
              
              
              52,329
              
              
              
              52,782
              
              
              
              21
              
              
              
              21Government-sponsored
      mortgage-backed residential
              
              
              57,853
              
              
              
              58,909
              
              
              
              107
              
              
              
              110Equity
              
              
              309
              
              
              
              312
              
              
              
              -
              
              
              
              -$
              162,899
              
              
              $
              164,750
              
              
              $
              128
              
              
              $
              131


For the
September 30, 2010 nine month period, proceeds from sales of available-for-sale
equity securities were $665,000 and net realized losses recognized in income
were $16,000.  There were no sales of available-for-sale securities
for the September 30, 2009 period.





Investment
securities pledged to secure public deposits and FHLB advances had an amortized
cost of $44.8 million and fair value of $45.6 million at September 30, 2010 and
a $28.6 million amortized cost and fair value of $28.8 million at December 31,
2009.





Securities
with unrealized losses at September 30, 2010 and December 31, 2009 aggregated by
major security type and length of time in a continuous unrealized loss position
are as follows:





September
      30, 2010
              
              Less
      than 12 Months
              
              
              12
      Months or More
              
              
              TotalFair
              
              
              Unrealized
              
              
              Fair
              
              
              Unrealized
              
              
              Fair
              
              
              UnrealizedDescription of Securities
              
              Value
              
              
              Loss
              
              
              Value
              
              
              Loss
              
              
              Value
              
              
              LossU.S.
      Treasury and agencies
              
              $
              4,980
              
              
              $
              (15
              )
              
              $
              -
              
              
              $
              -
              
              
              $
              4,980
              
              
              $
              (15
              )Government-sponsored
      mortgage-backed residential
              
              
              10,178
              
              
              
              (56
              )
              
              
              -
              
              
              
              -
              
              
              
              10,178
              
              
              
              (56
              )Equity
              
              
              3
              
              
              
              (5
              )
              
              
              -
              
              
              
              -
              
              
              
              3
              
              
              
              (5
              )State
      and municipal
              
              
              -
              
              
              
              -
              
              
              
              581
              
              
              
              (24
              )
              
              
              581
              
              
              
              (24
              )Trust
      preferred securities
              
              
              -
              
              
              
              -
              
              
              
              61
              
              
              
              (1,204
              )
              
              
              61
              
              
              
              (1,204
              )Total
      temporarily impaired
              
              $
              15,161
              
              
              $
              (76
              )
              
              $
              642
              
              
              $
              (1,228
              )
              
              $
              15,803
              
              
              $
              (1,304
              )
  December
      31, 2009
                
                Less
      than 12 Months
                
                
                12
      Months or More
                
                
                TotalFair
                
                
                Unrealized
                
                
                Fair
                
                
                Unrealized
                
                
                Fair
                
                
                UnrealizedDescription of Securities
                
                Value
                
                
                Loss
                
                
                Value
                
                
                Loss
                
                
                Value
                
                
                LossGovernment-sponsored
      mortgage-backed residential
                
                $
                5,141
                
                
                $
                (51
                )
                
                $
                -
                
                
                $
                -
                
                
                $
                5,141
                
                
                $
                (51
                )Equity
                
                
                75
                
                
                
                (3
                )
                
                
                -
                
                
                
                -
                
                
                
                75
                
                
                
                (3
                )State
      and municipal
                
                
                1,161
                
                
                
                (22
                )
                
                
                2,456
                
                
                
                (88
                )
                
                
                3,617
                
                
                
                (110
                )Trust
      preferred securities
                
                
                -
                
                
                
                -
                
                
                
                49
                
                
                
                (1,934
                )
                
                
                49
                
                
                
                (1,934
                )Total
      temporarily impaired
                
                $
                6,377
                
                
                $
                (76
                )
                
                $
                2,505
                
                
                $
                (2,022
                )
                
                $
                8,882
                
                
                $
                (2,098
                )





11




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





2.
            SECURITIES
      – (Continued)





We evaluate investment securities with
significant declines in fair value on a quarterly basis to determine whether
they should be considered other-than-temporarily impaired under current
accounting guidance, which generally provides that if a security is in an
unrealized loss position, whether due to general market conditions or industry
or issuer-specific factors, the holder of the securities must assess whether the
impairment is other-than-temporary.





Accounting
guidance requires entities to split other than temporary impairment charges
between credit losses (i.e., the loss based on the entity’s estimate of the
decrease in cash flows, including those that result from expected voluntary
prepayments), which are charged to earnings, and the remainder of the impairment
charge (non-credit component) to accumulated other comprehensive income. This
requirement pertains to both securities held to maturity and securities
available for sale.





The
unrealized losses on the state and municipal securities were caused primarily by
interest rate decreases.  The contractual terms of those investments
do not permit the issuer to settle the securities at a price less than the
amortized cost of the investment.  Because we do not have the intent
to sell these securities and it is likely that we will not be required to sell
the securities before their anticipated recovery, we do not consider these
investments to be other-than-temporarily impaired at September 30,
2010.  We also considered the financial condition and near term
prospects of the issuers and identified no matters that would indicate less than
full recovery.





As
discussed in Note 6 - Fair Value, the fair value of our portfolio of trust
preferred securities, has decreased significantly as a result of the current
credit crisis and lack of liquidity in the financial markets.  There
are limited trades in trust preferred securities and the majority of holders of
such instruments have elected not to participate in the market unless they are
required to sell as a result of liquidation, bankruptcy, or other forced or
distressed conditions.





To
determine if the five trust preferred securities were other than temporarily
impaired as of September 30, 2010, we used a discounted cash flow
analysis.  The cash flow models were used to determine if the current
present value of the cash flows expected on each security were still equivalent
to the original cash flows projected on the security when
purchased.   The cash flow analysis takes into consideration
assumptions for prepayments, defaults and deferrals for the underlying pool of
banks, insurance companies and REITs.





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





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


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


·
            We
      assume a recovery rate of 15% on deferrals after two
  years.


·
            We
      assume 2% prepayments through the five year par call and then 2% per annum
      for the remaining life of the
security.


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





12




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





2.
            SECURITIES
      – (Continued)





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





·
            Valuation
      estimates provided by our investment
broker;


·
            The
      amount of fair value decline;


·
            How
      long the decline in fair value has
existed;


·
            Significant
      rating agency changes on the
issuer;


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


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


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


·
            Other
      relevant observable inputs.





The
following table details the five debt securities with other-than-temporary
impairment at September 30, 2010 and the related credit losses recognized in
earnings during the nine months ended September 30 2010:





(Dollars
      in thousands)
              
              
              
              Moody's
      Credit Ratings When
              
              Current
      Moody's Credit
              
              Par
              
              
              Amortized
              
              
              Estimated
      Fair
              
              
              Current
      Deferrals and
              
              
              %
      of Current Deferrals and Defaults to Current
              
              
              OTTISecurity
              
              Tranche
              
              Purchased
              
              Ratings
              
              Value
              
              
              Cost
              
              
              Value
              
              
              Defaults
              
              
              Collateral
              
              
              RecognizedPreferred
      Term Securities IV
              
              Mezzanine
              
              
              A3
              
              Ca
              
              $
              244
              
              
              $
              187
              
              
              $
              24
              
              
              $
              18,000
              
              
              
              27
              %
              
              $
              12Preferred
      Term Securities VI
              
              Mezzanine
              
              
              A1
              
              Caa1
              
              
              259
              
              
              
              21
              
              
              
              21
              
              
              
              33,000
              
              
              
              81
              %
              
              
              50Preferred
      Term Securities XV B1
              
              Mezzanine
              
              
              A2
              
              Ca
              
              
              1,004
              
              
              
              475
              
              
              
              19
              
              
              
              209,450
              
              
              
              35
              %
              
              
              357Preferred
      Term Securities XXI C2
              
              Mezzanine
              
              
              A3
              
              Ca
              
              
              1,018
              
              
              
              440
              
              
              
              13
              
              
              
              215,890
              
              
              
              29
              %
              
              
              191Preferred
      Term Securities XXII C1
              
              Mezzanine
              
              
              A3
              
              Ca
              
              
              503
              
              
              
              163
              
              
              
              5
              
              
              
              396,500
              
              
              
              29
              %
              
              
              222Total
              
              
              
              
              
              
              
              
              $
              3,028
              
              
              $
              1,286
              
              
              $
              82
              
              
              
              
              
              
              
              
              
              
              $
              832


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





(Dollars
      in thousands)Beginning
      balance January 1, 2010
              
              $
              862Increases
      to the amount related to the credit loss for whichother-than-temporary
      impairment was previously recognized
              
              
              832Ending
      balance September 30, 2010
              
              $
              1,694




13





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS




3.
            LOANS





Loans are
summarized as follows:





September
      30,
              
              
              December
      31,(Dollars
      in thousands)
              
              2010
              
              
              2009Commercial
              
              $
              44,265
              
              
              $
              62,940Real
      estate commercial
              
              
              587,767
              
              
              
              627,788Real
      estate construction
              
              
              10,402
              
              
              
              14,567Residential
      mortgage
              
              
              169,763
              
              
              
              178,985Consumer
      and home equity
              
              
              77,080
              
              
              
              74,844Indirect
      consumer
              
              
              31,325
              
              
              
              36,628Loans
      held for sale
              
              
              13,213
              
              
              
              8,183933,815
              
              
              
              1,003,935Less:Net
      deferred loan origination fees
              
              
              (507
              )
              
              
              (826
              )Allowance
      for loan losses
              
              
              (20,091
              )
              
              
              (17,719
              )(20,598
              )
              
              
              (18,545
              )Loans
      Receivable
              
              $
              913,217
              
              
              $
              985,390




The
allowance for loan loss is summarized as follows:





Three
      Months Ended
              
              
              Nine
      Months EndedSeptember
      30,
              
              
              September
      30,(Dollars
      in thousands)
              
              2010
              
              
              2009
              
              
              2010
              
              
              2009Balance,
      beginning of period
              
              $
              20,953
              
              
              $
              14,236
              
              
              $
              17,719
              
              
              $
              13,565Provision
      for loan losses
              
              
              6,327
              
              
              
              2,482
              
              
              
              11,353
              
              
              
              6,441Charge-offs
              
              
              (7,276
              )
              
              
              (656
              )
              
              
              (9,180
              )
              
              
              (4,063
              )Recoveries
              
              
              87
              
              
              
              111
              
              
              
              199
              
              
              
              230Balance,
      end of period
              
              $
              20,091
              
              
              $
              16,173
              
              
              $
              20,091
              
              
              $
              16,173


Impaired
loans are summarized below.  There were no impaired loans for the
periods presented without an allowance allocation.





As
      of the
                Nine
      Months Ended
              
              
              As
      of the Year EndedSeptember
      30,
              
              
              December
      31,(Dollars
      in thousands)
              
              2010
              
              
              2009End
      of period impaired loans
              
              $
              100,093
              
              
              $
              66,956Amount
      of allowance for loan loss allocated
              
              
              10,086
              
              
              
              6,398




14





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





3.
            LOANS–
    (Continued)





We report
non-performing loans as impaired.  Our non-performing loans were as
follows:





September
      30,
              
              
              December
      31,(Dollars
      in thousands)
              
              2010
              
              
              2009Restructured
              
              $
              2,008
              
              
              $
              9,812Loans
      past due over 90 days still on accrual
              
              
              -
              
              
              
              -Non
      accrual loans
              
              
              58,054
              
              
              
              28,186Total
              
              $
              60,062
              
              
              $
              37,998


We have
allocated $358,000 of specific reserves to customers whose loan terms have been
modified in troubled debt restructurings as of September 30, 2010.  We
are not committed to lend additional funds to debtors whose loans have been
modified in a troubled debt restructuring.





4.
            REAL
      ESTATE ACQUIRED THROUGH FORECLOSURE





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





September
      30,
              
              
              December
      31,(Dollars
      in thousands)
              
              2010
              
              
              2009Beginning
      balance
              
              $
              8,428
              
              
              $
              5,925Additions
              
              
              9,471
              
              
              
              5,979Sales
              
              
              (4,367
              )
              
              
              (2,930
              )Writedowns
              
              
              (751
              )
              
              
              (546
              )Ending
      balance
              
              $
              12,781
              
              
              $
              8,428


5.
            EARNINGS
      (LOSS) PER SHARE





The
reconciliation of the numerators and denominators of the basic and diluted EPS
is as follows:





Three
      Months Ended
              
              
              Nine
      Months Ended(Dollars
      in thousands,
              
              September
      30,
              
              
              September
      30,except
      per share data)
              
              2010
              
              
              2009
              
              
              2010
              
              
              2009Basic:Net
      income/(loss)
              
              $
              (2,493
              )
              
              $
              576
              
              
              $
              (1,801
              )
              
              $
              2,052Less:Preferred
      stock dividends
              
              
              (250
              )
              
              
              (250
              )
              
              
              (750
              )
              
              
              (730
              )Accretion
      on preferred stock discount
              
              
              (14
              )
              
              
              (14
              )
              
              
              (41
              )
              
              
              (39
              )Net
      income/(loss) available to common shareholders
              
              $
              (2,757
              )
              
              $
              312
              
              
              $
              (2,592
              )
              
              $
              1,283Weighted
      average common shares
              
              
              4,724
              
              
              
              4,704
              
              
              
              4,720
              
              
              
              4,690Diluted:Weighted
      average common shares
              
              
              4,724
              
              
              
              4,704
              
              
              
              4,720
              
              
              
              4,690Dilutive
      effect of stock options and warrants
              
              
              -
              
              
              
              30
              
              
              
              -
              
              
              
              13Weighted
      average common and incremental shares
              
              
              4,724
              
              
              
              4,734
              
              
              
              4,720
              
              
              
              4,703Earnings/(Loss)
      Per Common Share:Basic
              
              $
              (0.58
              )
              
              $
              0.07
              
              
              $
              (0.55
              )
              
              $
              0.27Diluted
              
              $
              (0.58
              )
              
              $
              0.07
              
              
              $
              (0.55
              )
              
              $
              0.27




15




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS








5.
            EARNINGS (LOSS) PER SHARE
      –
      (Continued)





Stock
options for 235,021 shares of common stock were not included in the September
30, 2010 computation of diluted earnings per share for the quarter and year to
date because their impact was anti-dilutive.  Stock options for
127,590 and 154,505 shares of common stock were not included in the September
30, 2009 computation of diluted earnings per share for the quarter and year to
date because their impact was anti-dilutive. Warrants to purchase 215,983 shares
at September 30, 2010 were not included in the quarter and year to date
computation because their impact was anti-dilutive.





6.
            STOCK
      OPTION PLAN





Our 2006
Stock Incentive Plan, which is shareholder approved, succeeded our 1998 Stock
Option and Incentive Plan.  Under the 2006 Plan, we may grant either
incentive or non-qualified stock options tokey employees and
directorsfor a
total of 647,350 shares of our common stock at not less than fair value at the
date such options are granted.Options available for
future grant under the 1998 Plan totaled 38,500 shares and were rolled into the
2006 Plan.We
believe that the ability to award stock options and other forms of stock-based
incentive compensation can assist us in attracting and retaining key
employees.  Stock-based incentive compensation is also a means to
align the interests of key employees with those of our
shareholders  by  providing  awards  intended  to  reward   recipients  for  our  long-term  growth.The option to purchase
shares vest over periods of one to five years and expire ten years after the
date of grant.We
issue new shares of common stock upon the exercise of stock
options.  At September 30, 2010 options available for future grant
under the 2006 Plan totaled 494,750.Compensation cost
related to options granted under the 1998 and 2006 Plans that was charged
against earnings for the nine month periods ended September 30, 2010and 2009 was $71,000 and
$78,000.





The fair
value of each option award is estimated on the date of grant using the
Black-Scholes option valuation model that uses various weighted-average
assumptions.  The risk-free interest rate is based on the U.S.
Treasury yield curve in effect at the time of grant.  The expected
volatility is based on the fluctuation in the price of a share of stock over the
period for which the option is being valued and the expected life of the options
granted represents the period of time the options are expected to be
outstanding.  There were no stock option grants for the September 30,
2010 period.





A summary
of option activity under the 1998 and 2006 Plans as of September 30, 2010 is
presented below:





Number
      of Options
              
              
              Weighted
      Average Exercise Price
              
              
              Weighted
      Average Remaining Contractual Term
              
              
              Aggregate
      Intrinsic Value(Dollars
      In Thousands)Outstanding,
      beginning of period
              
              
              279,706
              
              
              $
              15.12Granted
      during period
              
              
              -
              
              
              
              -Forfeited
      during period
              
              
              (4,685
              )
              
              
              11.61Exercised
      during period
              
              
              -
              
              
              
              -Cancelled
      during period
              
              
              (40,000
              )
              
              
              9.06Outstanding,
      end of period
              
              
              235,021
              
              
              $
              16.23
              
              
              
              6.7
              
              
              $
              -Eligible
      for exercise at period end
              
              
              100,213
              
              
              $
              20.41
              
              
              
              4.5
              
              
              $
              -


There
were no options exercised, modified or settled in cash for the period ended
September 30, 2010.  The total intrinsic value of options exercised
during the period ended September 30, 2009 was $119,000.  There was no
tax benefit recognized from the option exercises as they are considered
incentive stock options.  Management expects all outstanding unvested
options will vest.





16




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS




6.
            STOCK
      OPTION PLAN–
      (Continued)





As of
September 30, 2010 there was $198,000 of total unrecognized compensation cost
related to non-vested share-based compensation arrangements granted under the
1998 and 2006 Plans.  That cost is expected to be recognized over a
weighted-average period of 3.0 years.  Cash received from option
exercises under all share-based payment arrangements for the periods ended
September 30, 2010 and 2009 was $0 and $101,000.





7.
            FAIR
      VALUE





U.S. GAAP
defines fair value as the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at
the measurement date and establishes a fair value hierarchy that prioritizes the
use of inputs used in valuation methodologies into the following three
levels:





Level 1: Quoted prices
(unadjusted) for identical assets or liabilities in active markets.  A
quoted price in an active market provides the most reliable evidence of
fair value and shall be used to measure fair value whenever
available.





Level 2:Significant other
observable inputs other than Level 1 prices such as quoted prices for similar
assets or liabilities; quoted prices in markets that are not active; or other
inputs that are observable or can be corroborated by observable market
data.





Level 3: Significant
unobservable inputs that reflect a reporting entity’s own assumptions about the
assumptions that market participants would use in pricing an asset or
liability.





We used
the following methods and significant assumptions to estimate the fair value of
available-for-sale-securities.





Available-for-sale
securities: The fair values of
some equity securities are determined by obtaining quoted prices on nationally
recognized securities exchanges (Level 1 inputs).  The fair values of
most debt securities are determined by a matrix pricing, which is a mathematical
technique widely used in the industry to value debt securities without relying
exclusively on quoted prices for the specific securities but rather by relying
on the securities’ relationship to other benchmark quoted securities (Level 2
inputs).  In certain cases where there is limited activity or less
transparency around inputs to the valuation, securities are classified within
(Level 3) of the valuation hierarchy.  For trust preferred securities,
discounted cash flows are calculated using spread to swap and LIBOR curves that
are updated to incorporate loss severities, volatility, credit spread and
optionality.  Rating agency and industry research reports as well as
defaults and deferrals on individual securities are reviewed and incorporated
into the calculations.  For other equity securities, discounted cash
flows are calculated with available market information through processes using
benchmark yields, market spreads sourced from new issues, dealer quotes and
trade prices among other sources.





17




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS








7.
            FAIR
      VALUE - (Continued)





Assets and Liabilities
Measured at Fair Value on a Recurring Basis





Assets
measured at fair value on a recurring basis are summarized below:





(Dollars
      in thousands)
            
            September
      30,
              2010
            
            
            Quoted
      Prices in Active Markets for Identical Assets
              (Level 1)
            
            
            Significant
      Other Observable Inputs
              (Level 2)
            
            
            Significant
      Unobservable Inputs
              (Level 3)Assets:U.S.
      Treasury and agencies
            
            $
            81,252
            
            
            $
            -
            
            
            $
            81,252
            
            
            $
            -Government-sponsored
      mortgage-backed residential
            
            
            58,909
            
            
            
            -
            
            
            
            58,909
            
            
            
            -Equity
            
            
            312
            
            
            
            21
            
            
            
            -
            
            
            
            291State
      and municipal
            
            
            24,216
            
            
            
            -
            
            
            
            24,216
            
            
            
            -Trust
      preferred securities
            
            
            61
            
            
            
            -
            
            
            
            -
            
            
            
            61Total
            
            $
            164,750
            
            
            $
            21
            
            
            $
            164,377
            
            
            $
            352




(Dollars
      in thousands)
              
              December
      31, 2009
              
              
              Quoted
      Prices in Active Markets for Identical Assets
                (Level 1)
              
              
              Significant
      Other Observable Inputs
                (Level 2)
              
              
              Significant
      Unobservable Inputs
                (Level 3)Assets:U.S.
      Treasury and agencies
              
              $
              20,080
              
              
              $
              -
              
              
              $
              20,080
              
              
              $
              -Government-sponsored
      mortgage-backed residential
              
              
              9,752
              
              
              
              -
              
              
              
              9,752
              
              
              
              -Equity
              
              
              990
              
              
              
              699
              
              
              
              -
              
              
              
              291State
      and municipal
              
              
              14,893
              
              
              
              -
              
              
              
              14,893
              
              
              
              -Trust
      preferred securities
              
              
              49
              
              
              
              -
              
              
              
              -
              
              
              
              49Total
              
              $
              45,764
              
              
              $
              699
              
              
              $
              44,725
              
              
              $
              340





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





Since
late 2007, the markets for collateralized debt obligations and trust preferred
securities have become increasingly inactive.  The inactivity began in
late 2007 when new issues of similar securities were discounted in order to
complete the offering.  Beginning in the second quarter of 2008, the
purchase and sale activity of these securities substantially decreased as
investors elected to hold the securities instead of selling them at
substantially depressed prices.  Our brokers have indicated that
little if any activity is occurring in this sector and that the PreTSL
securities trades that are taking place are primarily distressed sales where the
seller must liquidate as a result of insolvency, redemptions or closure of a
fund holding the security, or other distressed conditions.  As a
result, the bid-ask spreads have widened significantly and the volume of trades
decreased significantly compared to historical volumes.





18




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





7.
            FAIR
      VALUE - (Continued)





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





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





We
received valuation estimates on our trust preferred securities for September 30,
2010.  Those valuation estimates were based on proprietary pricing
models utilizing significant unobservable inputs in an inactive market with
distressed sales, Level 3 inputs, rather than actual transactions in an active
market.  In accordance with current accounting guidance, we determined
that a risk-adjusted discount rate appropriately reflects the reporting entity’s
estimate of the assumptions that market participants would use in an active
market to estimate the selling price of the asset at the measurement
date.





We
conduct a thorough review of fair value hierarchy classifications on a quarterly
basis.  Reclassification of certain financial instruments may occur
when input observability changes.





The table
below presents a reconciliation and income statement classification of gains and
losses for all assets measured at fair value on a recurring basis using
significant unobservable inputs (Level 3) for the three and nine month periods
ended September 30, 2010 and 2009:





Fair
      Value Measurements Using Significant Unobservable Inputs (Level
      3)Three
      Months Ended
              
              
              Nine
      Months EndedSeptember
      30,
              
              
              September
      30,(Dollars
      in thousands)
              
              2010
              
              
              2009
              
              
              2010
              
              
              2009Beginning
      balance
              
              $
              334
              
              
              $
              539
              
              
              $
              340
              
              
              $
              364Total
      gains or losses:Impairment
      charges on securities
              
              
              (649
              )
              
              
              (304
              )
              
              
              (782
              )
              
              
              (679
              )Included
      in other comprehensive income
              
              
              667
              
              
              
              108
              
              
              
              794
              
              
              
              658Transfers
      in and/or out of Level 3
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Ending
      balance
              
              $
              352
              
              
              $
              343
              
              
              $
              352
              
              
              $
              343
  19





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS




7.
            FAIR
      VALUE - (Continued)





Assets and Liabilities
Measured at Fair Value on a Nonrecurring Basis





Assets
measured at fair value on a nonrecurring basis are summarized
below:





(Dollars
      in thousands)
            
            September
      30,
              2010
            
            
            Quoted
      Prices in Active Markets for Identical Assets
              (Level 1)
            
            
            Significant
      Other Observable Inputs
              (Level 2)
            
            
            Significant
      Unobservable Inputs
              (Level 3)Assets:Impaired
      loans
            
            $
            37,094
            
            
            $
            -
            
            
            $
            -
            
            
            $
            37,094Real
      estate acquired through foreclosure
            
            
            5,154
            
            
            
            -
            
            
            
            -
            
            
            
            5,154Trust
      preferred security held-to-maturity
            
            
            21
            
            
            
            -
            
            
            
            -
            
            
            
            21




(Dollars
      in thousands)
              
              December
      31,
                2009
              
              
              Quoted
      Prices in Active Markets for Identical Assets
                (Level 1)
              
              
              Significant
      Other Observable Inputs
                (Level 2)
              
              
              Significant
      Unobservable Inputs
                (Level 3)Assets:Impaired
      loans
              
              $
              27,841
              
              
              $
              -
              
              
              $
              -
              
              
              $
              27,841Real
      estate acquired through foreclosure
              
              
              3,799
              
              
              
              -
              
              
              
              -
              
              
              
              3,799Trust
      preferred security held-to-maturity
              
              
              20
              
              
              
              -
              
              
              
              -
              
              
              
              20





Impaired
loans, which are measured for impairment using the fair value of the collateral
for collateral dependent loans, had a carrying amount of $46.8 million, with a
valuation allowance of $9.7 million, resulting in an additional provision for
loan losses of $3.8 million and $8.6 million for the three and nine month
periods ended September 30, 2010.  Values for collateral dependent
loans are generally based on appraisals obtained from licensed real estate
appraisals and in certain circumstances consideration of offers obtained to
purchase properties prior to foreclosure.  Appraisals for commercial
real estate generally use three methods to derive value: cost, sales or market
comparison and income approach.  The cost method bases value on the
estimated cost to replace the current property after considering adjustments for
depreciation.  Values of the market comparison approach evaluate the
sales price of similar properties in the same market area.  The income
approach considers net operating income generated by the property and an
investors required return.  The final value is a reconciliation of
these three approaches and takes into consideration any other factors management
deems relevant to arrive at a representative fair value.





Real
estate owned acquired through foreclosure is recorded at fair value less
estimated selling costs at the date of foreclosure.  Fair value is
based on the appraised market value of the property based on sales of similar
assets.  The fair value may be subsequently reduced if the estimated
fair value declines below the original appraised value.  Fair value
adjustments of $363,000 and $751,000 were made to real estate owned during the
three and nine month periods ended September 30, 2010.





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





We
received valuation estimates on our trust preferred security for September 30,
2010.  Those valuation estimates were based on proprietary pricing
models utilizing significant unobservable inputs in an inactive market with
distressed sales, Level 3 inputs, rather than actual transactions in an active
market.




20





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS




7.
            FAIR
      VALUE - (Continued)





Fair Value of Financial
Instruments





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




September
      30, 2010
                
                
                December
      31, 2009Carrying
                
                
                Fair
                
                
                Carrying
                
                
                Fair(Dollars
      in thousands)
                
                Value
                
                
                Value
                
                
                Value
                
                
                ValueFinancial
      assets:Cash
      and due from banks
                
                $
                88,998
                
                
                $
                88,998
                
                
                $
                98,533
                
                
                $
                98,533Securities
      held-to-maturity
                
                
                107
                
                
                
                110
                
                
                
                1,147
                
                
                
                1,156Loans
      held for sale
                
                
                13,213
                
                
                
                13,390
                
                
                
                8,183
                
                
                
                8,257Loans,
      net
                
                
                862,910
                
                
                
                875,753
                
                
                
                949,366
                
                
                
                954,743Accrued
      interest receivable
                
                
                6,248
                
                
                
                6,248
                
                
                
                5,658
                
                
                
                5,658FHLB
      stock
                
                
                5,015
                
                
                
                N/A
                
                
                
                8,515
                
                
                
                N/AFinancial
      liabilities:Deposits
                
                
                1,088,726
                
                
                
                1,092,518
                
                
                
                1,049,815
                
                
                
                1,042,957Short-term
      borrowings
                
                
                345
                
                
                
                345
                
                
                
                1,500
                
                
                
                1,500Advances
      from Federal Home Loan Bank
                
                
                52,564
                
                
                
                53,677
                
                
                
                52,745
                
                
                
                55,856Subordinated
      debentures
                
                
                18,000
                
                
                
                12,743
                
                
                
                18,000
                
                
                
                12,743Accrued
      interest payable
                
                
                246
                
                
                
                246
                
                
                
                360
                
                
                
                360





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





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





8.
            PREFERRED
      STOCK





On
January 9, 2009, we issued $20 million of cumulative perpetual preferred
shares, with a liquidation preference of $1,000 per share (the “Senior Preferred
Shares”) to the United States Treasury under its Capital Purchase Program
(“CPP”). The Senior Preferred Shares constitute Tier 1 capital and rank senior
to our common shares. The Senior Preferred Shares pay cumulative dividends
quarterly at a rate of 5% per annum for the first five years and will reset to a
rate of 9% per annum after five years. The Senior Preferred Shares may be
redeemed at any time, at our option. We also have the ability to defer dividend
payments at any time, at our option.





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




21





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS




8.
            PREFERRED
      STOCK - (Continued)





On
October 29, 2010, we gave written notice to the United States Treasury that we
were suspending the payment of regular quarterly cash dividends on our fixed
rate cumulative perpetual preferred stock, Series A (“Series A Preferred
Stock”).    Since the dividends are cumulative, failure to
pay dividends for six periods would trigger board appointment rights for the
holder of the Series A Preferred Stock.  The dividends will continue
to be accrued for payment in the future and reported as a preferred dividend
requirement that is deducted from income to common shareholders for financial
statement purposes.





Participation
in the CPP requires a participating institution to comply with a number of
restrictions and provisions, including standards for executive compensation and
corporate governance and limitations on share repurchases and the declaration
and payment of dividends on common shares. The standard terms of the CPP require
that a participating financial institution limit the payment of dividends to the
most recent quarterly amount prior to October 14, 2008, which is $0.19 per
share in our case. This dividend limitation will remain in effect until the
earlier of three years or such time that the preferred shares are
redeemed.





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





9.
            REGULATORY
      MATTERS





The Bank
currently has a regulatory agreement with the FDIC that requires us to obtain
the consent of the Regional Director of the FDIC and the Commissioner of the
KDFI to declare and pay cash dividends.  We also have a regulatory
agreement with the FDIC that requires us to maintain a Tier 1 leverage ratio of
8%.  We currently are not in compliance with the Tier 1 capital
requirement. To achieve the Tier 1 capital requirement that we have agreed to
with the FDIC, we plan on reducing the size of our balance sheet, raising
additional capital by selling common or preferred stock in the private or public
markets and recapitalizing other elements of our capital structure. The
Corporation has entered into an agreement with the Federal
Reserve.  Under this agreement, we must obtain regulatory approval
before declaring any dividends.  We may not redeem shares or obtain
additional borrowings without prior approval.




On
October 29, 2010, in an effort to preserve capital at the Bank and cash at the
Holding Company we also exercised our right to defer regularly scheduled
interest payments on both issues of junior subordinated notes, together having
an outstanding principal amount of $18 million, relating to outstanding trust
preferred securities.







22




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





9.
            REGULATORY
      MATTERS - (Continued)





The
following table shows the ratios of Tier 1 capital and total capital to
risk-adjusted assets and the leverage ratios for the Corporation and the Bank as
of September 30, 2010.





(Dollars
      in thousands)
              
              Actual
              
              
              For
      Capital Adequacy Purposes
              
              
              To
      Be Considered Well Capitalized Under Prompt Correction Action
      ProvisionsAs
      of September 30, 2010:
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      risk-based capital (to risk- weighted assets)Consolidated
              
              $
              112,634
              
              
              
              11.98
              %
              
              $
              75,226
              
              
              
              8.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              112,202
              
              
              
              11.94
              
              
              
              75,171
              
              
              
              8.00
              
              
              
              93,964
              
              
              
              10.00Tier
      I capital (to risk-weighted assets)Consolidated
              
              
              100,777
              
              
              
              10.72
              
              
              
              37,613
              
              
              
              4.00
              
              
              
              N/A
              
              
              
              N/ABank
              
              
              100,344
              
              
              
              10.68
              
              
              
              37,586
              
              
              
              4.00
              
              
              
              56,378
              
              
              
              6.00Tier
      I capital (to average assets)Consolidated
              
              
              100,777
              
              
              
              8.02
              
              
              
              50,249
              
              
              
              4.00
              
              
              
              N/A
              
              
              
              N/ABank
              
              
              100,344
              
              
              
              7.98
              
              
              
              50,297
              
              
              
              4.00
              
              
              
              62,872
              
              
              
              5.00





(Dollars
      in thousands)
              
              Actual
              
              
              For
      Capital
                Adequacy
      Purposes
              
              
              To
      Be Considered
                Well
      Capitalized
                Under
      Prompt
                Correction
                Action
      ProvisionsAs
      of December 31, 2009:
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      risk-based capital (to risk- weighted assets)Consolidated
              
              $
              115,702
              
              
              
              11.35
              %
              
              $
              81,550
              
              
              
              8.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              114,514
              
              
              
              11.25
              
              
              
              81,467
              
              
              
              8.00
              
              
              
              101,834
              
              
              
              10.00Tier
      I capital (to risk-weighted assets)Consolidated
              
              
              102,894
              
              
              
              10.09
              
              
              
              40,775
              
              
              
              4.00
              
              
              
              N/A
              
              
              
              N/ABank
              
              
              101,719
              
              
              
              9.99
              
              
              
              40,734
              
              
              
              4.00
              
              
              
              61,100
              
              
              
              6.00Tier
      I capital (to average assets)Consolidated
              
              
              102,894
              
              
              
              8.66
              
              
              
              47,533
              
              
              
              4.00
              
              
              
              N/A
              
              
              
              N/ABank
              
              
              101,719
              
              
              
              8.90
              
              
              
              45,732
              
              
              
              4.00
              
              
              
              57,165
              
              
              
              5.00
  23




Item 2.


MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION


AND
RESULTS OF OPERATIONS





GENERAL





We
operate 22 full-service banking centers and a commercial private banking center
in eight contiguous counties in central Kentucky along the Interstate 65
corridor and within the Louisville metropolitan area, including southern
Indiana.  Our markets range from Louisville in Jefferson County,
Kentucky approximately 40 miles north of our headquarters in Elizabethtown,
Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown
to Harrison County, Indiana approximately 60 miles northwest of our
headquarters.  Our markets are supported by a diversified industry
base and have a regional population of over 1 million.  We operate in
Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky and in
Harrison and Floyd counties in southern Indiana.





We serve
the needs and cater to the economic strengths of the local communities in which
we operate, and we strive to provide a high level of personal and professional
customer service. We offer a variety of financial services to our retail and
commercial banking customers. These services include personal and corporate
banking services and personal investment financial counseling
services.





Throughour personal investment
financial counseling services, we offer a wide variety of mutual funds, equity
investments, and fixed and variable annuities.  We invest in the
wholesale capital markets to manage a portfolio of securities and use various
forms of wholesale funding. The security portfolio contains a variety of
instruments, including callable debentures, taxable and non-taxable debentures,
fixed and adjustable rate mortgage backed securities, and collateralized
mortgage obligations.





Our
results of operations depend primarily on net interest income, which is the
difference between interest income from interest-earning assets and interest
expense on interest-bearing liabilities. Our operations are also affected by
non-interest income, such as service charges, loan fees, gains and losses from
the sale of mortgage loans and revenue earned from bank owned life insurance.
Our principal operating expenses, aside from interest expense, consist of
compensation and employee benefits, occupancy costs, data processing expense,
FDIC insurance premiums and provisions for loan losses.





The
discussion and analysis section covers material changes in the financial
condition since December 31, 2009 and material changes in the results of
operations for the three and nine month periods ending September 30, 2010 as
compared to the same periods in 2009.  It should be read in
conjunction with "Management’s Discussion and Analysis of Financial Condition
and Results of Operations" included in the Annual Report on Form 10-K for the
period ended December 31, 2009.





OVERVIEW





Over the
past several years we have focused on enhancing and expanding our retail and
commercial banking network in our core central Kentucky markets as well as
establishing our presence in the metropolitan Louisville market.  Our
core markets, where we have a combined 22% market share, have become
increasingly competitive as several new banks have entered those markets during
the past few years.  In order to protect and grow our market share, we
have replaced existing branches with newer, enhanced facilities.  In
addition to the enhancement and expansion in our core markets, we have been
increasing our presence in the Louisville market.  Our acquisition of
FSB Bancshares, Inc. has broadened our retail branch network in the Louisville
MSA, which now extends into southern Indiana.  Approximately 55% of
the deposit base in the Louisville market is controlled by five out-of-state
banks.  While the market is very competitive, we believe this creates
an opportunity for smaller community banks with more power to make decisions
locally.  We believe our investment in these initiatives along with
our continued commitment to a high level of customer service will enhance our
market share in our core markets and our development in the Louisville
market.





Our
performance this quarter reflects higher provisions for loan losses and an
increase in non-performing assets.  Non-performing assets to total
assets increased to 5.84% for the quarter ended September 30, 2010, compared to
4.19% for the quarter ended June 30, 2010, due primarily to four high-end
residential development projects, aggregating $22.7 million in loans, located in
Jefferson and Oldham Counties, Kentucky.  These four projects coupled
with three other residential development projects in that area account for $34.4
million or 47% of the bank’s nonperforming assets.  The primary
weakness in the residential development portfolio is concentrated in the
Louisville metropolitan area.   In our markets surrounding the
Ft. Knox military base, residential activity remains robust as a result of the
increase in 3,200 civilian families relocating to Ft. Knox with the Base
Realignment and Closure Act.  The Army’s Human Resource Command is
being relocated to the Ft. Knox military base, resulting in a substantial
economic benefit to this area.




24





Although
we had a disappointing quarter in our loan portfolio, we believe that the
strength of our retail franchise will enhance our ability to
persevere through this economic recovery.This is evidenced by
our total deposits increasing $38.9 million, or 3.7% for the first
nine months of 2010, continuing the momentum from 2009 where we achieved a
record growth year in the amount of $274.4 million, or a 35.3% increase in total
deposits over 2008.  Growth in deposits, coupled with positive signs
of economic growth in our home markets, which is fueled by the Ft. Knox base
realignment, will provide a sound basis for us as the local economy
recovers.  Recognizing that we are still not immune to economic
concerns, the opportunity for deposits helps us strive towards our long range
financial objectives.  These objectives include building additional
core customer relationships, maintaining sufficient liquidity and capital
levels, improving shareholder value and remediating our problem
assets.





CRITICAL
ACCOUNTING POLICIES





Our
accounting and reporting policies comply with U.S. generally accepted accounting
principles and conform to general practices within the banking
industry.  The accounting policy relating to the allowance for loan
losses is critical to the understanding of our results of operations since the
application of this policy requires significant management assumptions and
estimates that could result in materially different amounts to be reported if
conditions or underlying circumstances were to change.





Allowance for
Loan Losses–We
maintain an allowance sufficient to absorb probable incurred credit losses
existing in the loan portfolio. Our Allowance for Loan Loss Review Committee,
which is comprised of senior officers, evaluates the allowance for loan losses
on a monthly basis.  We estimate the allowance using past loan loss
experience, known and inherent risks in the portfolio, adverse situations that
may affect the borrower’s ability to repay, estimated value of the underlying
collateral, and current economic conditions.  While we estimate the
allowance for loan losses based in part on historical losses within each loan
category, estimates for losses within the commercial real estate portfolio
depend more on credit analysis and recent payment performance. Allocations of
the allowance may be made for specific loans or loan categories, but the entire
allowance is available for any loan that, in management’s judgment, should be
charged off.





The
allowance consists of specific and general components.  The specific
component relates to loans that are individually classified as impaired or loans
otherwise classified as substandard or doubtful.  The general
component covers non-classified loans and is based on historical loss experience
adjusted for current factors. Allowance estimates are developed with actual loss
experience adjusted for current economic conditions.  Allowance
estimates are considered a prudent measurement of the risk in the loan portfolio
and are applied to individual loans based on loan type.





Based on
our calculation, an allowance of $20.1 millionor 2.18% of total loans
was our estimate of probable losses within the loan portfolio as ofSeptember 30, 2010.This estimate required
a provision for loan losses on the income statement of$11.4 million for the
2010 nine month period.If the mix and amount of future charge off percentages differ
significantly from those assumptions used by management in making its
determination, the allowance for loan losses and provision for loan losses on
the income statement could materially increase.





Impairment of
Investment Securities–We review all unrealized losses on our investment securities to determine
whether the losses are other-than-temporary.  We evaluate our
investment securities on at least a quarterly basis and more frequently when
economic or market conditions warrant, to determine whether a decline in their
value below amortized cost is other-than-temporary.  We evaluate a
number of factors including, but not limited to: valuation estimates provided by
investment brokers; how much fair value has declined below amortized cost; how
long the decline in fair value has existed; the financial condition of the
issuer; significant rating agency changes on the issuer; and management’s
assessment that we do not intend to sell or will not be required to sell the
security for a period of time sufficient to allow for any anticipated recovery
in fair value.





The term
“other-than-temporary” is not intended to indicate that the decline is
permanent, but indicates that the possibility for a near-term recovery of value
is not necessarily favorable, or that there is a lack of evidence to support a
realizable value equal to or greater than the carrying value of the
investment.  Once a decline in value is determined to be
other-than-temporary, the cost basis of the security is written down to fair
value and a charge to earnings is recognized for the credit component and the
non-credit component is recorded to other comprehensive income.





Real estate
owned–The
estimation of fair value is significant to real estate owned acquired through
foreclosure.  These assets are recorded at fair value less estimated
selling costs at the date of foreclosure.  Fair value is based on the
appraised market value of the property based on sales of similar assets when
available.  The fair value may be subsequently reduced if the
estimated fair value declines below the original appraised value.




25





RESULTS
OF OPERATIONS





Net loss
for the quarter ended September 30, 2010 was $(2.5) million or $(0.58) per
common share compared to net income of $576,000 or $0.07 per common share
diluted for the same period in 2009. Net loss for the nine
month period ended September 30, 2010 was $(1.8) million or $(0.55) per common
share diluted compared to net income of $2.1 million or $0.27 per common
share diluted for the same period a year ago.  Earnings decreased for
2010 compared to 2009 due to a decrease in our net interest margin, an increase
in provision for loan loss expense, write downs taken on investment securities
that were other-than-temporarily impaired, write downs taken on real estate
acquired through foreclosure, higher FDIC insurance premiums and a higher level
of other non-interest expense. Net income available to common shareholders was
also impacted by dividends paid on preferred shares. Our book value per
common share decreased from $15.80 at September 30, 2009 to $13.79 at September
30, 2010.





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





The
increase in the volume of interest earning assets was off-set by the change in
the mix of interest earning assets, causing a negative impact on net interest
income, which decreased $291,000 and $16,000 for the three and nine month 2010
periods compared to the same prior year periods.  Average interest
earning assets increased $162.7 million for the 2010 quarter and $181.9 million
for the nine months compared to 2009.  Despite the increase in
interest earning assets, our net interest margin realized a sharp
decline.  The decline is primarily attributed to our efforts to
increase liquidity by placing assets into lower yielding investments other than
loans.  The decrease is also partially attributed to the increase in
the amount of non-accrual loans.  The yield on earning assets averaged
5.00% and 5.10% for the three and nine month 2010 periods compared to an average
yield on earning assets of 5.75% and 5.85% for the same periods in
2009.  This decrease was offset somewhat by a decrease in our
cost of funds.  Net interest margin as a percent of average earning
assets decreased57
basis points to 3.07% for the quarter ended September 30, 2010 and 55 basis
points to 3.14% for the nine months ended September 30, 2010 compared to 3.64%
and 3.69% for the same periods in 2009.





Our cost
of funds averaged 2.10% and 2.14% for the quarter and nine month periods of 2010
compared to an average cost of funds of 2.29% and 2.36% for the same period in
2009. Going forward, our cost of funds is expected to continue to decrease as
certificates of deposit re-price and roll off into new certificates of deposit
at lower interest rates.





Competition
for deposits combined with continued re-pricing of variable rate loans and our
efforts to increase liquidity by placing assets into lower yielding investments
other than loans is likely to compress our net interest margin in future
quarters.




26





AVERAGE
BALANCE SHEET





The
following table provides information relating to our average balance sheet and
reflects the average yield on assets and average cost of liabilities for the
indicated periods.  Yields and costs for the periods presented are
derived by dividing income or expense by the average balances of assets or
liabilities, respectively.




Quarter
      Ended September 30,2010
              
              
              2009Average
              
              
              
              
              
              Average
              
              
              Average
              
              
              
              
              
              Average(Dollars
      in thousands)
              
              Balance
              
              
              Interest
              
              
              Yield/Cost (5)
              
              
              Balance
              
              
              Interest
              
              
              Yield/Cost (5)ASSETSInterest
      earning assets:U.S.
      Treasury and agencies
              
              $
              78,358
              
              
              $
              486
              
              
              
              2.46
              %
              
              $
              12,908
              
              
              $
              75
              
              
              
              2.31
              %Mortgage-backed
      securities
              
              
              47,240
              
              
              
              454
              
              
              
              3.81
              
              
              
              6,373
              
              
              
              65
              
              
              
              4.05Equity
      securities
              
              
              382
              
              
              
              12
              
              
              
              12.46
              
              
              
              977
              
              
              
              25
              
              
              
              10.15State
      and political subdivisionsecurities
      (1)
              
              
              22,925
              
              
              
              387
              
              
              
              6.70
              
              
              
              12,580
              
              
              
              207
              
              
              
              6.53Corporate
      bonds
              
              
              1,910
              
              
              
              27
              
              
              
              5.61
              
              
              
              2,381
              
              
              
              26
              
              
              
              4.33Loans
      (2) (3)
      (4)
              
              
              944,861
              
              
              
              13,543
              
              
              
              5.69
              
              
              
              984,468
              
              
              
              14,410
              
              
              
              5.81FHLB
      stock
              
              
              6,558
              
              
              
              91
              
              
              
              5.51
              
              
              
              8,515
              
              
              
              103
              
              
              
              4.80Interest
      bearing deposits
              
              
              91,356
              
              
              
              47
              
              
              
              0.20
              
              
              
              2,706
              
              
              
              18
              
              
              
              2.64Total interest earning
      assets
              
              
              1,193,590
              
              
              
              15,047
              
              
              
              5.00
              
              
              
              1,030,908
              
              
              
              14,929
              
              
              
              5.75Less:  Allowance
      for loan losses
              
              
              (20,342
              )
              
              
              
              
              
              
              
              
              
              
              (14,753
              )Non-interest
      earning assets
              
              
              84,050
              
              
              
              
              
              
              
              
              
              
              
              87,857Total
    assets
              
              $
              1,257,298
              
              
              
              
              
              
              
              
              
              
              $
              1,104,012LIABILITIES
      ANDSTOCKHOLDERS'
      EQUITYInterest
      bearing liabilities:Savings
      accounts
              
              $
              105,843
              
              
              $
              218
              
              
              
              0.82
              %
              
              $
              115,882
              
              
              $
              236
              
              
              
              0.81
              %NOW
      and money marketaccounts
              
              
              273,120
              
              
              
              751
              
              
              
              1.09
              
              
              
              179,348
              
              
              
              352
              
              
              
              0.78Certificates
      of deposit andother
      time deposits
              
              
              648,647
              
              
              
              3,914
              
              
              
              2.39
              
              
              
              525,372
              
              
              
              3,925
              
              
              
              2.96Short
      term borrowings
              
              
              429
              
              
              
              6
              
              
              
              5.55
              
              
              
              57,235
              
              
              
              27
              
              
              
              0.19FHLB
      advances
              
              
              52,575
              
              
              
              599
              
              
              
              4.52
              
              
              
              52,788
              
              
              
              601
              
              
              
              4.52Subordinated
      debentures
              
              
              18,000
              
              
              
              331
              
              
              
              7.30
              
              
              
              18,000
              
              
              
              331
              
              
              
              7.30Total interest bearing
      liabilities
              
              
              1,098,614
              
              
              
              5,819
              
              
              
              2.10
              
              
              
              948,625
              
              
              
              5,472
              
              
              
              2.29Non-interest
      bearing liabilities:Non-interest
      bearing deposits
              
              
              69,671
              
              
              
              
              
              
              
              
              
              
              
              58,176Other
      liabilities
              
              
              3,252
              
              
              
              
              
              
              
              
              
              
              
              3,481Total
      liabilities
              
              
              1,171,537
              
              
              
              
              
              
              
              
              
              
              
              1,010,282Stockholders'
      equity
              
              
              85,761
              
              
              
              
              
              
              
              
              
              
              
              93,730Total liabilities
      andstockholders'
      equity
              
              $
              1,257,298
              
              
              
              
              
              
              
              
              
              
              $
              1,104,012Net
      interest income
              
              
              
              
              
              $
              9,228
              
              
              
              
              
              
              
              
              
              
              $
              9,457Net
      interest spread
              
              
              
              
              
              
              
              
              
              
              2.90
              %
              
              
              
              
              
              
              
              
              
              
              3.46
              %Net
      interest margin
              
              
              
              
              
              
              
              
              
              
              3.07
              %
              
              
              
              
              
              
              
              
              
              
              3.64
              %
  (1)Taxable equivalent
      yields are calculated assuming a 34% federal income tax
    rate.(2)Includes loan fees,
      immaterial in amount, in both interest income and the calculation of yield
      on loans.(3)Calculations include
      non-accruing loans in the average loan amounts
  outstanding.(4)Includes loans held
      for sale.(5)Annualized




27




Nine
      Months Ended September 30,2010
              
              
              2009Average
              
              
              
              
              
              Average
              
              
              Average
              
              
              
              
              
              Average(Dollars
      in thousands)
              
              Balance
              
              
              Interest
              
              
              Yield/Cost (5)
              
              
              Balance
              
              
              Interest
              
              
              Yield/Cost (5)ASSETSInterest
      earning assets:U.S.
      Treasury and agencies
              
              $
              57,351
              
              
              $
              1,113
              
              
              
              2.59
              %
              
              $
              7,915
              
              
              $
              177
              
              
              
              2.99
              %Mortgage-backed
      securities
              
              
              28,776
              
              
              
              857
              
              
              
              3.98
              
              
              
              7,058
              
              
              
              221
              
              
              
              4.19Equity
      securities
              
              
              571
              
              
              
              47
              
              
              
              11.01
              
              
              
              953
              
              
              
              82
              
              
              
              11.50State
      and political subdivisionsecurities
      (1)
              
              
              19,450
              
              
              
              952
              
              
              
              6.54
              
              
              
              10,961
              
              
              
              547
              
              
              
              6.67Corporate
      bonds
              
              
              1,929
              
              
              
              74
              
              
              
              5.13
              
              
              
              2,613
              
              
              
              86
              
              
              
              4.40Loans
      (2) (3)
      (4)
              
              
              965,978
              
              
              
              41,857
              
              
              
              5.79
              
              
              
              963,728
              
              
              
              42,509
              
              
              
              5.90FHLB
      stock
              
              
              7,863
              
              
              
              275
              
              
              
              4.68
              
              
              
              8,515
              
              
              
              290
              
              
              
              4.55Interest
      bearing deposits
              
              
              104,484
              
              
              
              122
              
              
              
              0.16
              
              
              
              2,749
              
              
              
              69
              
              
              
              3.36Total interest earning
      assets
              
              
              1,186,402
              
              
              
              45,297
              
              
              
              5.10
              
              
              
              1,004,492
              
              
              
              43,981
              
              
              
              5.85Less:  Allowance
      for loan losses
              
              
              (18,822
              )
              
              
              
              
              
              
              
              
              
              
              (14,465
              )Non-interest
      earning assets
              
              
              82,971
              
              
              
              
              
              
              
              
              
              
              
              84,899Total
    assets
              
              $
              1,250,551
              
              
              
              
              
              
              
              
              
              
              $
              1,074,926LIABILITIES
      ANDSTOCKHOLDERS'
      EQUITYInterest
      bearing liabilities:Savings
      accounts
              
              $
              116,571
              
              
              $
              684
              
              
              
              0.78
              %
              
              $
              115,323
              
              
              $
              634
              
              
              
              0.74
              %NOW
      and money marketaccounts
              
              
              262,838
              
              
              
              2,250
              
              
              
              1.14
              
              
              
              166,202
              
              
              
              861
              
              
              
              0.69Certificates
      of deposit andother
      time deposits
              
              
              642,049
              
              
              
              11,708
              
              
              
              2.44
              
              
              
              502,542
              
              
              
              11,864
              
              
              
              3.16Short
      term borrowings
              
              
              698
              
              
              
              38
              
              
              
              7.28
              
              
              
              66,866
              
              
              
              117
              
              
              
              0.23FHLB
      advances
              
              
              52,624
              
              
              
              1,788
              
              
              
              4.54
              
              
              
              52,737
              
              
              
              1,798
              
              
              
              4.56Subordinated
      debentures
              
              
              18,000
              
              
              
              989
              
              
              
              7.35
              
              
              
              18,000
              
              
              
              989
              
              
              
              7.35Total interest bearing
      liabilities
              
              
              1,092,780
              
              
              
              17,457
              
              
              
              2.14
              
              
              
              921,670
              
              
              
              16,263
              
              
              
              2.36Non-interest
      bearing liabilities:Non-interest
      bearing deposits
              
              
              67,801
              
              
              
              
              
              
              
              
              
              
              
              57,230Other
      liabilities
              
              
              3,724
              
              
              
              
              
              
              
              
              
              
              
              3,093Total
      liabilities
              
              
              1,164,305
              
              
              
              
              
              
              
              
              
              
              
              981,993Stockholders'
      equity
              
              
              86,246
              
              
              
              
              
              
              
              
              
              
              
              92,933Total liabilities
      andstockholders'
      equity
              
              $
              1,250,551
              
              
              
              
              
              
              
              
              
              
              $
              1,074,926Net
      interest income
              
              
              
              
              
              $
              27,840
              
              
              
              
              
              
              
              
              
              
              $
              27,718Net
      interest spread
              
              
              
              
              
              
              
              
              
              
              2.96
              %
              
              
              
              
              
              
              
              
              
              
              3.49
              %Net
      interest margin
              
              
              
              
              
              
              
              
              
              
              3.14
              %
              
              
              
              
              
              
              
              
              
              
              3.69
              %
  (1)Taxable equivalent
      yields are calculated assuming a 34% federal income tax
    rate.(2)Includes loan fees,
      immaterial in amount, in both interest income and the calculation of yield
      on loans.(3)Calculations include
      non-accruing loans in the average loan amounts
  outstanding.(4)Includes loans held
      for sale.(5)Annualized


28





RATE/VOLUME
ANALYSIS





The table
below shows changes in interest income and interest expense for the periods
indicated.  For each category of interest-earning assets and
interest-bearing liabilities, information is provided on changes attributable to
(1) changes in rate (changes in rate multiplied by old volume); (2) changes in
volume (change in volume multiplied by old rate); and (3) changes in rate-volume
(change in rate multiplied by change in volume).  Changes in
rate-volume are proportionately allocated between rate and volume
variance.


Three
      Months Ended
              
              
              Nine
      Months EndedSeptember
      30,
              
              
              September
      30,2010 vs. 2009
              
              
              2010 vs. 2009Increase
      (decrease)
              
              
              Increase
      (decrease)Due
      to change in
              
              
              Due
      to change inNet
              
              
              
              
              
              
              
              
              Net(Dollars
      in thousands)
              
              Rate
              
              
              Volume
              
              
              Change
              
              
              Rate
              
              
              Volume
              
              
              ChangeInterest
      income:U.S.
      Treasury and agencies
              
              $
              5
              
              
              $
              406
              
              
              $
              411
              
              
              $
              (27
              )
              
              $
              963
              
              
              $
              936Mortgage-backed
      securities
              
              
              (4
              )
              
              
              393
              
              
              
              389
              
              
              
              (11
              )
              
              
              647
              
              
              
              636Equity
      securities
              
              
              5
              
              
              
              (18
              )
              
              
              (13
              )
              
              
              (4
              )
              
              
              (31
              )
              
              
              (35
              )State
      and political subdivisionsecurities
              
              
              6
              
              
              
              174
              
              
              
              180
              
              
              
              (11
              )
              
              
              416
              
              
              
              405Corporate
      bonds
              
              
              7
              
              
              
              (6
              )
              
              
              1
              
              
              
              13
              
              
              
              (25
              )
              
              
              (12
              )Loans
              
              
              (295
              )
              
              
              (572
              )
              
              
              (867
              )
              
              
              (751
              )
              
              
              99
              
              
              
              (652
              )FHLB
      stock
              
              
              14
              
              
              
              (26
              )
              
              
              (12
              )
              
              
              7
              
              
              
              (22
              )
              
              
              (15
              )Interest
      bearing deposits
              
              
              (31
              )
              
              
              60
              
              
              
              29
              
              
              
              (127
              )
              
              
              180
              
              
              
              53Total
      interest earning assets
              
              
              (293
              )
              
              
              411
              
              
              
              118
              
              
              
              (911
              )
              
              
              2,227
              
              
              
              1,316Interest
      expense:Savings
      accounts
              
              
              3
              
              
              
              (21
              )
              
              
              (18
              )
              
              
              43
              
              
              
              7
              
              
              
              50NOW
      and money market accounts
              
              
              173
              
              
              
              226
              
              
              
              399
              
              
              
              735
              
              
              
              654
              
              
              
              1,389Certificates
      of deposit and othertime
      deposits
              
              
              (835
              )
              
              
              824
              
              
              
              (11
              )
              
              
              (3,038
              )
              
              
              2,882
              
              
              
              (156
              )Short
      term borrowings
              
              
              31
              
              
              
              (52
              )
              
              
              (21
              )
              
              
              148
              
              
              
              (227
              )
              
              
              (79
              )FHLB
      advances
              
              
              1
              
              
              
              (3
              )
              
              
              (2
              )
              
              
              (6
              )
              
              
              (4
              )
              
              
              (10
              )Subordinated
      debentures
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -
              
              
              
              -Total
      interest bearing liabilities
              
              
              (627
              )
              
              
              974
              
              
              
              347
              
              
              
              (2,118
              )
              
              
              3,312
              
              
              
              1,194Net
      change in net interest income
              
              $
              334
              
              
              $
              (563
              )
              
              $
              (229
              )
              
              $
              1,207
              
              
              $
              (1,085
              )
              
              $
              122
  Non-Interest
Income and Non-Interest Expense





The
following tables compare the components of non-interest income and expenses for
the periods ended September 30, 2010 and 2009.  The tables show the
dollar and percentage change from 2009 to 2010.  Below each table is a
discussion of significant changes and trends.





Three
      Months EndedSeptember
      30,(Dollars in
thousands)
              
              2010
              
              
              2009
              
              
              Change
              
              
              %Non-interest
      incomeCustomer
      service fees on deposit accounts
              
              $
              1,671
              
              
              $
              1,750
              
              
              $
              (79
              )
              
              
              -4.5
              %Gain
      on sale of mortgage loans
              
              
              513
              
              
              
              300
              
              
              
              213
              
              
              
              71.0
              %Gain
      on sale of investments
              
              
              7
              
              
              
              -
              
              
              
              7
              
              
              
              100.0
              %Net
      impairment losses recognized in earnings
              
              
              (649
              )
              
              
              (304
              )
              
              
              (345
              )
              
              
              113.5
              %Loss
      on sale and write downs of real estate acquiredthrough
      foreclosure
              
              
              (374
              )
              
              
              (305
              )
              
              
              (69
              )
              
              
              22.6
              %Brokerage
      commissions
              
              
              109
              
              
              
              89
              
              
              
              20
              
              
              
              22.5
              %Other
      income
              
              
              703
              
              
              
              365
              
              
              
              338
              
              
              
              92.6
              %$
              1,980
              
              
              $
              1,895
              
              
              $
              85
              
              
              
              4.5
              %


29




Nine
      Months EndedSeptember
      30,(Dollars in
thousands)
              
              2010
              
              
              2009
              
              
              Change
              
              
              %Non-interest
      incomeCustomer
      service fees on deposit accounts
              
              $
              4,935
              
              
              $
              4,872
              
              
              $
              63
              
              
              
              1.3
              %Gain
      on sale of mortgage loans
              
              
              1,227
              
              
              
              832
              
              
              
              395
              
              
              
              47.5
              %Loss
      on sale of investments
              
              
              (16
              )
              
              
              -
              
              
              
              (16
              )
              
              
              100.0
              %Net
      impairment losses recognized in earnings
              
              
              (832
              )
              
              
              (703
              )
              
              
              (129
              )
              
              
              18.3
              %Loss
      on sale and write downs of real estate acquiredthrough
      foreclosure
              
              
              (838
              )
              
              
              (555
              )
              
              
              (283
              )
              
              
              51.0
              %Brokerage
      commissions
              
              
              309
              
              
              
              281
              
              
              
              28
              
              
              
              10.0
              %Other
      income
              
              
              1,514
              
              
              
              1,263
              
              
              
              251
              
              
              
              19.9
              %$
              6,299
              
              
              $
              5,990
              
              
              $
              309
              
              
              
              5.2
              %


We
originate qualified VA, KHC, RHC and conventional secondary market loans and
sell them into the secondary market with servicing rights
released.  Prevailing mortgage interest rates remained at attractive
levels during the period helping to contribute to the increase in the volume of
loans closed for 2010.





We invest
in various types of liquid assets, including United States Treasury obligations,
securities of various federal agencies, obligations of states and political
subdivisions, corporate bonds, mutual funds, stocks and
others.  During the third quarter of 2010 we recorded gains on the
sale of equity investment securities of $7,000.





We
recognized other-than-temporary impairment charges of $832,000 for the expected
credit loss during the 2010 period on all five of our trust preferred securities
compared to $703,000 of impairment charges for 2009. Management believes this
impairment was primarily attributable to the current economic environment which
caused the financial conditions of some of the issuers to
deteriorate.





Further
reducing non-interest income for 2010 was an increase of $283,000 in losses on
the sale and write down of real estate owned properties.




The
increase in other income is primarily the result of gains recorded on the sale
of real estate owned properties.




Three
      Months EndedSeptember
      30,(Dollars in thousands)
              
              2010
              
              
              2009
              
              
              Change
              
              
              %Non-interest
      expensesEmployee
      compensation and benefits
              
              $
              4,176
              
              
              $
              4,042
              
              
              $
              134
              
              
              
              3.3
              %Office
      occupancy expense and equipment
              
              
              779
              
              
              
              832
              
              
              
              (53
              )
              
              
              -6.4
              %Marketing
      and advertising
              
              
              225
              
              
              
              225
              
              
              
              -
              
              
              
              0.0
              %Outside
      services and data processing
              
              
              622
              
              
              
              793
              
              
              
              (171
              )
              
              
              -21.6
              %Bank
      franchise tax
              
              
              566
              
              
              
              257
              
              
              
              309
              
              
              
              120.2
              %FDIC
      insurance premiums
              
              
              615
              
              
              
              414
              
              
              
              201
              
              
              
              48.6
              %Amortization
      of core deposit intangible
              
              
              77
              
              
              
              100
              
              
              
              (23
              )
              
              
              -23.0
              %Real
      estate acquired through foreclosure expense
              
              
              302
              
              
              
              124
              
              
              
              178
              
              
              
              143.5
              %Other
      expense
              
              
              1,352
              
              
              
              1,241
              
              
              
              111
              
              
              
              8.9
              %$
              8,714
              
              
              $
              8,028
              
              
              $
              686
              
              
              
              8.5
              %




30




Nine
      Months EndedSeptember
      30,(Dollars in thousands)
              
              2010
              
              
              2009
              
              
              Change
              
              
              %Non-interest
      expensesEmployee
      compensation and benefits
              
              $
              12,171
              
              
              $
              12,193
              
              
              $
              (22
              )
              
              
              -0.2
              %Office
      occupancy expense and equipment
              
              
              2,351
              
              
              
              2,488
              
              
              
              (137
              )
              
              
              -5.5
              %Marketing
      and advertising
              
              
              675
              
              
              
              735
              
              
              
              (60
              )
              
              
              -8.2
              %Outside
      services and data processing
              
              
              2,020
              
              
              
              2,381
              
              
              
              (361
              )
              
              
              -15.2
              %Bank
      franchise tax
              
              
              1,482
              
              
              
              778
              
              
              
              704
              
              
              
              90.5
              %FDIC
      insurance premiums
              
              
              1,969
              
              
              
              1,381
              
              
              
              588
              
              
              
              42.6
              %Amortization
      of core deposit intangible
              
              
              229
              
              
              
              302
              
              
              
              (73
              )
              
              
              -24.2
              %Real
      estate acquired through foreclosure expense
              
              
              916
              
              
              
              366
              
              
              
              550
              
              
              
              150.3
              %Other
      expense
              
              
              3,809
              
              
              
              3,632
              
              
              
              177
              
              
              
              4.9
              %$
              25,622
              
              
              $
              24,256
              
              
              $
              1,366
              
              
              
              5.6
              %





Office
occupancy expense and equipment and marketing and advertising expense decreased
in 2010 compared to 2009. These expenses were higher in 2009 due to additional
operating expenses related to the opening of two new banking centers. We opened
a full-service banking center at Fort Knox and another in the Middletown area of
Jefferson County in 2009.





Outside
services and data processing decreased due the renewal of our data processing
contracts at a lower monthly cost.





During
the fourth quarter of 2009, the FDIC adopted a requirement that all banks prepay
three and a quarter years worth of FDIC assessments on December 31,
2009.  The prepayment is based on average third quarter
deposits.  The prepaid amount will be amortized over the prepayment
period.  Our prepayment was $7.5 million of which $2.0 million was
reflected in our 2010 income statement.  Given the enacted increases
in
assessments  for  insured  financial  institutions  in  2009,  we
anticipate  that  FDIC  assessments  on
deposits will have a significantly greater impact upon operating expenses for
the next few years.





The
increase in real estate acquired through foreclosure expense for the 2010 nine
month period was primarily due to $375,000 in back taxes being paid on a
commercial real estate property that was taken into other real estate owned
during the period.





Our
efficiency ratio was 76% for 2010 compared to 72% for the 2009
period.





ANALYSIS
OF FINANCIAL CONDITION





Total
assets at September 30, 2010 increased $39.3 million from December 31, 2009. The
increase was due to building our investment portfolio to $164.9 million, an
increase of $117.9 million since December 31, 2009.  This increase was
mainly off-set by a decline in gross loans of $74.8 million and a decrease in
cash and cash equivalents of $9.5 million.  This shift in the balance
sheet reflects a conscious effort by management to add on-balance sheet
liquidity to protect us against any adverse changes to our current wholesale
funding position.





Loans





Net loans
decreased $73.2 million to $913.2 million at September 30, 2010 compared to
$985.4 million at December 31, 2009.  Our commercial real estate and
commercial portfolios decreased $58.7 million to $632.0 million at September 30,
2010.  Our residential mortgage loan, real estate construction and
indirect consumer portfolios all decreased for the 2010 period while our
consumer and home equity loan portfolio increased $2.2 million.  The
decline in our commercial real estate and commercial loan portfolios is a result
of pay-offs on several large commercial relationships.  The loan
portfolio also declined due to our aggressive efforts to resolve problem
loans.  During 2010, we took deeds in lieu of foreclosure on several
large commercial real estate properties, moving them to our other real estate
owned portfolio. Although
there remains a high demand for loans from quality borrowers, we have elected to
shift our focus to preserve capital.  We believe however, we will
still be well positioned to benefit from growth in our local markets as the
economy rebounds.




31





September
      30,
              
              
              December
      31,(Dollars
      in thousands)
              
              2010
              
              
              2009Commercial
              
              $
              44,265
              
              
              $
              62,940Real
      estate commercial
              
              
              587,767
              
              
              
              627,788Real
      estate construction
              
              
              10,402
              
              
              
              14,567Residential
      mortgage
              
              
              169,763
              
              
              
              178,985Consumer
      and home equity
              
              
              77,080
              
              
              
              74,844Indirect
      consumer
              
              
              31,325
              
              
              
              36,628Loans
      held for sale
              
              
              13,213
              
              
              
              8,183933,815
              
              
              
              1,003,935Less:Net
      deferred loan origination fees
              
              
              (507
              )
              
              
              (826
              )Allowance
      for loan losses
              
              
              (20,091
              )
              
              
              (17,719
              )(20,598
              )
              
              
              (18,545
              )Loans
      Receivable
              
              $
              913,217
              
              
              $
              985,390





Allowance
and Provision for Loan Losses





Our
financial performance depends on the quality of the loans we originate and
management’s ability to assess the degree of risk in existing loans when it
determines the allowance for loan losses.  An increase in loan
charge-offs or non-performing loans or an inadequate allowance for loan losses
could reduce net interest income, net income and capital and limit the range of
products and services we can offer.





The
Allowance for Loan Loss Review Committee evaluates the allowance for loan losses
monthly to maintain a level sufficient to absorb probable incurred credit losses
existing in the loan portfolio.  Periodic provisions to the allowance
are made as needed.  The Committee determines the allowance by
applying loss estimates to graded loans by categories, as described
below.  In addition, the Committee analyzes such factors as changes in
lending policies and procedures; underwriting standards; collection; charge-off
and recovery history; changes in national and local economic business conditions
and developments; changes in the characteristics of the portfolio; ability and
depth of lending management and staff; changes in the trend of the volume and
severity of past due, non-accrual and classified loans; troubled debt
restructuring and other loan modifications; and results of regulatory
examinations.





Further
declines in collateral values, including commercial real estate, may impact our
ability to collect on certain loans when borrowers are dependent on the values
of the real estate as a source of cash flow.




32





The
following table analyzes our loan loss experience for the periods
indicated.





Three
      Months Ended
            
            
            Nine
      Months EndedSeptember
      30,
            
            
            September
      30,(Dollars
      in thousands)
            
            2010
            
            
            2009
            
            
            2010
            
            
            2009Balance
      at beginning of period
            
            $
            20,953
            
            
            $
            14,236
            
            
            $
            17,719
            
            
            $
            13,565Loans
      charged-off:Residential
      mortgage
            
            
            165
            
            
            
            573
            
            
            
            165
            
            
            
            614Consumer
      & home equity
            
            
            141
            
            
            
            83
            
            
            
            463
            
            
            
            570Commercial
      & commercial real estate
            
            
            6,970
            
            
            
            -
            
            
            
            8,552
            
            
            
            2,879Total
      charge-offs
            
            
            7,276
            
            
            
            656
            
            
            
            9,180
            
            
            
            4,063Recoveries:Residential
      mortgage
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            2Consumer
      & home equity
            
            
            39
            
            
            
            62
            
            
            
            136
            
            
            
            179Commercial
      & commercial real estate
            
            
            48
            
            
            
            49
            
            
            
            63
            
            
            
            49Total
      recoveries
            
            
            87
            
            
            
            111
            
            
            
            199
            
            
            
            230Net
      loans charged-off
            
            
            7,189
            
            
            
            545
            
            
            
            8,981
            
            
            
            3,833Provision
      for loan losses
            
            
            6,327
            
            
            
            2,482
            
            
            
            11,353
            
            
            
            6,441Balance
      at end of period
            
            $
            20,091
            
            
            $
            16,173
            
            
            $
            20,091
            
            
            $
            16,173Allowance
      for loan losses to total loans(excluding
      loans held for sale)
            
            
            
            
            
            
            
            
            
            
            2.18
            %
            
            
            1.65
            %Annualized
      net charge-offs to averageloans
      outstanding
            
            
            
            
            
            
            
            
            
            
            1.24
            %
            
            
            0.53
            %Allowance
      for loan losses tototal
      non-performing loans
            
            
            
            
            
            
            
            
            
            
            33
            %
            
            
            46
            %


The
provision for loan losses increased $3.8 million to $6.3 million for the quarter
ended September 30, 2010, and increased $4.9 million to $11.4 million for the
nine months ended September 30, 2010 compared to the same periods in
2009.  During the first nine months of 2010, we continued our efforts
to ensure the adequacy of the allowance by adding specific reserves to several
large commercial real estate relationships based on updated appraisals of the
underlying collateral.  We require
appraisals on real estate at the time of initial application and subsequently
assess the transaction and market conditions to determine if updated appraisals
are periodically needed.  Additionally, we evaluate the collateral
condition and value upon classification as an impaired loan and upon
foreclosure. The
higher provision was also due to our increasing the general reserve provisioning
levels for commercial real estate loans due to the increase in classified loans
for the 2010 period.  The allowance for loan losses increased $3.9
million to $20.1 million from September 30, 2009 to September 30, 2010. The increase was due to
specific reserves placed on loans due to updated appraisal information obtained
as part of our on-going monitoring of the loan portfolio, as well as the
provision recorded to reflect an increase in classified loans for the 2010
period.  The increase in charge-offs for 2010 was primarily attributed
to charging down previously recorded specific reserves on non-performing loans
whose condition worsened during the third quarter of 2010.





Federal
regulations require banks to classify their own assets on a regular
basis.  The regulations provide for three categories of classified
loans -- substandard, doubtful and loss.





The
following table provides information with respect to criticized and classified
loans as of the dates indicated:





September
      30,
              
              
              June
      30,
              
              
              March
      31,
              
              
              December
      31,
              
              
              September
      30,
              
              
              September
      30,(Dollars in thousands)
              
              2010
              
              
              2010
              
              
              2010
              
              
              2009
              
              
              2009
              
              
              2008Criticized
      Loans:Total
      Criticized
              
              $
              29,285
              
              
              $
              52,564
              
              
              $
              53,359
              
              
              $
              63,456
              
              
              $
              55,265
              
              
              $
              51,657Classified
      Loans:Substandard
              
              $
              97,544
              
              
              $
              74,305
              
              
              $
              65,028
              
              
              $
              65,408
              
              
              $
              66,264
              
              
              $
              32,070Doubtful
              
              
              43
              
              
              
              463
              
              
              
              407
              
              
              
              370
              
              
              
              1,182
              
              
              
              -Loss
              
              
              2,506
              
              
              
              231
              
              
              
              26
              
              
              
              1,178
              
              
              
              93
              
              
              
              55Total
      Classified
              
              $
              100,093
              
              
              $
              74,999
              
              
              $
              65,461
              
              
              $
              66,956
              
              
              $
              67,539
              
              
              $
              32,125
  33


As we
focused on credit quality during 2008, 2009 and 2010, there was a significant
migration of loans into the substandard loan category.  If economic
conditions continue to put stress on our borrowers going forward, this may
require higher provisions for loan losses in future periods.  Credit
quality will continue to be a primary focus during the rest of 2010 and going
forward.





The $32.1
million increase in substandard assets for 2010 was primarily the resultof downgrading loans
withthirteen
borrowers with balances ranging from $1.0 million to $9.9 million. This
caused the percentage of allowance for loan loss to total non-performing loans
to decrease to 33% as of September 30, 2010 compared to 46% at September 30,
2009. Offsetting
this increase was the transfer of three classified loans totaling $7.4 million
to real estate acquired through foreclosure and the upgrades of three classified
loans totaling $8.9 million whose cash flow is adequate to service the debt.
Approximately $56.8 million of the total classified loans were related to real
estate development or real estate construction loans in our market area. 
Several
of the non-performing loans that were added during the quarter were adequately
collateralized and therefore did not require additional
reserves. Classified
consumer loans totaled $1.4 million, classified mortgage loans totaled $5.9
million andclassified commercial
loans totaled $36.0 million.  The
change in our level of allowance for loan losses is a result of a consistent
allowance methodology that is driven by risk factors. For more
information on collection efforts, evaluation of collateral and how loss amounts
are estimated, see “Non-Performing Assets,” below.





Although
we may allocate a portion of the allowance to specific loans or loan categories,
the entire allowance is available for active charge-offs.  We develop
our allowance estimates based on actual loss experience adjusted for current
economic conditions.  Allowance estimates represent a prudent
measurement of the risk in the loan portfolio, which we apply to individual
loans based on loan type.





Non-Performing
Assets





Non-performing
assets consist of certain restructured loans for which interest rate or other
terms have been renegotiated, loans on which interest is no longer accrued, real
estate acquired through foreclosure and repossessed assets.   We
do not have any loans longer than 90 days past due still on
accrual.  Loans, including impaired loans, are placed on non-accrual
status when they become past due 90 days or more as to principal or interest,
unless they are adequately secured and in the process of
collection.  Loans are considered impaired when we no longer
anticipate full principal or interest payments in accordance with the
contractual loan terms.  If a loan is impaired, we allocate a portion
of the allowance so that the loan is reported, net, at the present value of
estimated future cash flows using the loan’s existing rate, or at the fair value
of collateral if repayment is expected solely from collateral.





We review
our loans on a regular basis and implement normal collection procedures when a
borrower fails to make a required payment on a loan.  If the
delinquency on a mortgage loan exceeds 90 days and is not cured through normal
collection procedures or an acceptable arrangement is not worked out with the
borrower, we institute measures to remedy the default, including commencing a
foreclosure action.  We generally charge off consumer loans when
management deems a loan uncollectible and any available collateral has been
liquidated.  We handle commercial business and real estate loan
delinquencies on an individual basis with the advice of legal
counsel.





We
recognize interest income on loans on the accrual basis except for those loans
in a non-accrual of income status. We discontinue accruing interest on impaired
loans when management believes, after consideration of economic and business
conditions and collection efforts that the borrowers’ financial condition is
such that collection of interest is doubtful, typically after the loan becomes
90 days delinquent.  When we discontinue interest accrual, we reverse
existing accrued interest and subsequently recognize interest income only to the
extent we receive cash payments.





We
classify real estate acquired as a result of foreclosure or by deed in lieu of
foreclosure as real estate owned until such time as it is sold. We classify new
and used automobile, motorcycle and all terrain vehicles acquired as a result of
foreclosure as repossessed assets until they are sold. When such property is
acquired we record it at the lower of the unpaid principal balance of the
related loan or its fair value.  We charge any write-down of the
property at the time of acquisition to the allowance for loan
losses.  Subsequent gains and losses are included in non-interest
income and non-interest expense.





Real
estate owned acquired through foreclosure is recorded at fair value less
estimated selling costs at the date of foreclosure.  Fair value is
based on the appraised market value of the property based on sales of similar
assets.  The fair value may be subsequently reduced if the estimated
fair value declines below the original appraised value. We monitor market
information and the age of appraisals on existing real estate owned properties
and obtain new appraisals as circumstances warrant. Real estate acquired through
foreclosure increased $4.4 million to $12.8 million at September 30,
2010.  The increase was primarily the result of foreclosures involving
four commercial real estate properties totaling $6.4 million that were
transferred during the first nine months of 2010. Offsetting this increase was
the sale of two commercial real estate properties totaling $1.9
million.  All
properties held in other real estate owned are listed for sale with various
independent real estate agents.




34








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





September
      30,
              
              
              December
      31,(Dollars
      in thousands)
              
              2010
              
              
              2009Beginning
      balance
              
              $
              8,428
              
              
              $
              5,925Additions
              
              
              9,471
              
              
              
              5,979Sales
              
              
              (4,367
              )
              
              
              (2,930
              )Writedowns
              
              
              (751
              )
              
              
              (546
              )Ending
      balance
              
              $
              12,781
              
              
              $
              8,428


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





September
      30,
              
              
              December
      31,(Dollar
      in thousands)
              
              2010
              
              
              2009Restructured
              
              $
              2,008
              
              
              $
              9,812Past
      due 90 days still on accrual
              
              
              -
              
              
              
              -Loans
      on non-accrual status
              
              
              58,054
              
              
              
              28,186Total
      non-performing loans
              
              
              60,062
              
              
              
              37,998Real
      estate acquired through foreclosure
              
              
              12,781
              
              
              
              8,428Other
      repossessed assets
              
              
              48
              
              
              
              103Total
      non-performing assets
              
              $
              72,891
              
              
              $
              46,529Interest
      income that would have been earnedon
      non-performing loans
              
              $
              3,478
              
              
              $
              2,234Interest
      income recognized on non-performingloans
              
              
              261
              
              
              
              211Ratios:  Non-performing
      loans to total loans(excluding
      loans held for sale)
              
              
              6.53
              %
              
              
              3.82
              %Non-performing
      assets to total assets
              
              
              5.84
              %
              
              
              3.85
              %
  Non-performing
loans increased $22.1 million to $60.1 million at September 30, 2010 compared to
$38.0 million at December 31, 2009.  Non-accrual loans increased due
to the addition of eight credit relationships totaling $41.7
million.  The non-accrual credit relationships are secured by
real estate and we have provided adequate allowance based on current
information.  Offsetting this increase was a $5.1 credit relationship
being removed from the non-accrual category when the loan was re-written with
new guarantors and three non-accrual relationships totaling $6.6 million were
transferred to real estate acquired through foreclosure.  All
non-performing loans are considered impaired.





Non-performing
assets for the 2010 period include $2.0 million in restructured commercial,
mortgage and consumer loans.  Our restructured loans primarily consist
of four credit relationships with balances ranging from $109,000 to $1.3
million.  The terms of these loans have been renegotiated to reduce
the rate of interest or extend the term, thus reducing the amount of cash flow
required from the borrower to service the loans. The borrowers are currently
meeting the terms of the restructured loans.  The decrease in
restructured loans from December 31, 2009 is due to a credit relationship
totaling $6.1 million that was transferred to non-accrual status. Additional
decreases include the removal of two credit relationships totaling $3.2 million
from the restructured category since the terms of the loans are now
substantially equivalent to terms on which loans with comparable risks are being
made and the borrowers have performed according to the terms of the contract for
the past 18 to 24 months.





Investment
Securities





Interest
on securities provides us our largest source of interest income after interest
on loans, constituting 6.9% of the total interest income for the nine month
period ended September 30, 2010.  The securities portfolio serves as a
source of liquidity and earnings and contributes to the management of interest
rate risk.  We have the authority to invest in various types of liquid
assets, including short-term United States Treasury obligations and securities
of various federal agencies, obligations of states and political subdivisions,
corporate bonds, certificates of deposit at insured savings and loans and banks,
bankers' acceptances, and federal funds.  We may also invest a portion
of our assets in certain commercial paper and corporate debt
securities.  We are also authorized to invest in mutual funds and
stocks whose assets conform to the investments that we are authorized to make
directly. The available-for-sale investment portfolio increased $119.0 million
due to our purchase of government-sponsored mortgage-backed securities, U.S.
Government agency securities and state and municipal obligations. Offsetting
this increase was the sale of equity securities. The held-to-maturity investment
portfolio decreased $1.0 million as securities were called for redemption in
accordance with their terms due to decreasing rates.




35





We review
all unrealized losses at least on a quarterly basis to determine whether the
losses are other than temporary and more frequently when economic or market
concerns warrant. We consider the length of time and the extent to which the
fair value has been less than cost, the financial condition and near-term
prospects of the issuer, and whether management has the intent to sell the debt
security or whether it is more likely than not that we will be required to sell
the debt security before its anticipated recovery.  In analyzing an
issuer’s financial condition, we may consider whether the securities are issued
by the federal government or its agencies, whether downgrades by bond rating
agencies have occurred, and the results of reviews of the issuer’s financial
condition.




The
unrealized losses on the state and municipal securities were caused primarily by
interest rate decreases.  The contractual terms of those investments
do not permit the issuer to settle the securities at a price less than the
amortized cost of the investment.  Because we do not have the intent
to sell these securities and it is likely that we will not be required to sell
the securities before their anticipated recovery, we do not consider these
investments to be other-than-temporarily impaired at September 30,
2010.  We also considered the financial condition and near term
prospects of the issuer and identified no matters that would indicate less than
full recovery.





We have
evaluated the decline in the fair value of the trust preferred securities we
hold, which are directly related to the credit and liquidity crisis being
experienced in the financial services industry over the past
year.   The trust preferred securities market is currently
inactive making the valuation of trust preferred securities very
difficult.  The trust preferred securities are valued by management
using unobservable inputs through a discounted cash flow analysis as permitted
under current accounting guidance and using the expected cash flows
appropriately discounted using present value techniques.   Refer to
Note 7 – Fair Value for more information.





We
recognized other-than-temporary impairment charges of $832,000 for the expected
credit loss during the 2010 period on all five of the trust preferred securities
we hold with an original cost basis of $3.0 million.  All of our trust
preferred securities are currently rated below investment grade. One of our
trust preferred securities continues to pay interest as scheduled through
September 30, 2010, and is expected to continue paying interest as
scheduled.  The other four trust preferred securities are paying
either partial or full interest in kind instead of full cash
interest.    See Note 2 – Securities for more
information.  Management will continue to evaluate these securities
for impairment quarterly.




Recent
accounting guidance requires entities to split other than temporarily impaired
charges between credit losses (i.e., the loss based on the entity’s estimate of
the decrease in cash flows, including those that result from expected voluntary
prepayments), which are charged to earnings, and the remainder of the impairment
charge (non-credit component) to accumulated other comprehensive income. This
requirement pertains to both securities held to maturity and securities
available for sale.





Deposits





We rely
primarily on providing excellent customer service and long-standing
relationships with customers to attract and retain deposits. Market interest
rates and rates on deposit products offered by competing financial institutions
can significantly affect our ability to attract and retain
deposits.  We attract both short-term and long-term deposits from the
general public by offering a wide range of deposit accounts and interest rates.
In recent years market conditions have caused us to rely increasingly on
short-term certificate accounts and other deposit alternatives that are more
responsive to market interest rates.  We use forecasts based on
interest rate risk simulations to assist management in monitoring our use of
certificates of deposit and other deposit products as funding sources and the
impact of the use of those products on interest income and net interest margin
in various rate environments.





Total
deposits increased $38.9 million year to date compared to December 31, 2009 due
to successful deposit promotions.  Retail and commercial deposits
increased $153.8 million.  Public funds, brokered deposits and
Certificate of Deposit Account Registry Service (“CDARS”) certificates
decreased$114.9
million.  Brokered deposits were $66.0 million at September 30, 2010
compared to $127.8 million at December 31, 2009.




36





The
following table breaks down our deposits.





September
      30,
              
              
              December
      31,2010
              
              
              2009(In
      Thousands)Non-interest
      bearing
              
              $
              70,288
              
              
              $
              63,950NOW
      demand
              
              
              120,897
              
              
              
              117,319Savings
              
              
              97,069
              
              
              
              131,401Money
      market
              
              
              150,904
              
              
              
              127,885Certificates
      of deposit
              
              
              649,568
              
              
              
              609,260$
              1,088,726
              
              
              $
              1,049,815
  Short-Term
Borrowings





Short-term
borrowings consist of a loan agreement with a correspondent bank for 2010 and
primarily federal funds purchased from the FHLB of Cincinnati for
2009.  We had short-term borrowings of $345,000 at September 30, 2010
and $2.2 million at September 30, 2009.  These borrowings averaged a
rate of 7.28% and .25% for 2010 and 2009.





Advances
from Federal Home Loan Bank





Deposits
are the primary source of funds for our lending and investment activities and
for our general business purposes.  We can also use advances
(borrowings) from the Federal Home Loan Bank (FHLB) of Cincinnati to compensate
for reductions in deposits or deposit inflows at less than projected
levels.  At September 30, 2010 we had $52.6 million in advances
outstanding from the FHLB.  However,
we did not have sufficient collateral available for additional borrowings form
the FHLB. Advances
from the FHLB are secured by our stock in the FHLB, certain securities, certain
commercial real estate loans and substantially all of our first mortgage,
multi-family and open end home equity loans.  We had $561.6 million in
loans pledged under this arrangement at September 30, 2010.





Subordinated
Debentures





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





A
different trust subsidiary issued 30 year cumulative trust preferred securities
totaling $10 million at a 10 year fixed rate of 6.69% adjusting quarterly
thereafter at LIBOR plus 160 basis points.  The subordinated
debentures, which mature March 22, 2037, can be called at par in whole or in
part on or after March 15, 2017.  We have the option to defer interest
payments on the subordinated debt from time to time for a period not to exceed
five consecutive years. The subordinated debentures are considered as Tier I
capital for the Corporation under current regulatory guidelines.





Our trust
subsidiaries loaned the proceeds of their offerings of trust preferred
securities to us in exchange for junior subordinated deferrable interest
debentures. In accordance with current accounting guidance, these trusts are not
consolidated with our financial statements but rather the subordinated
debentures are shown as a liability.





On
October 29, 2010, we exercised our right to defer regularly scheduled interest
payments on both issues of junior subordinated notes, together having an
outstanding principal amount of $18 million, relating to outstanding trust
preferred securities.  We have the right to defer payments of interest
for up to 20 consecutive quarterly periods without default or
penalty.  After such period, we must pay all deferred interest and
resume quarterly interest payments or we will be in default. During the deferral
period, the respective statutory trusts, which are wholly owned subsidiaries of
First Financial Service Corporation, that were formed to issue the trust
preferred securities, will likewise suspend the declaration and payment of
dividends on the trust preferred securities.  The regular scheduled
interest payments will continue to be accrued for payment in the future and
reported as an expense for financial statement purposes.




37




LIQUIDITY





Liquidity
risk arises from the possibility we may not be able to satisfy current or future
financial commitments, or may become unduly reliant on alternative funding
sources. The objective of liquidity risk management is to ensure that we can
meet the cash flow requirements of depositors and borrowers, as well as our
operating cash needs, at a reasonable cost, taking into account all on- and
off-balance sheet funding demands. Our investment and funds management policy
identifies the primary sources of liquidity, establishes procedures for
monitoring and measuring liquidity, and establishes minimum liquidity
requirements in compliance with regulatory guidance. The Asset Liability
Committee continually monitors our liquidity position.





Our
sources of funds include the sale of securities in the available-for-sale
portion of the investment portfolio, the payment of principal on loans and
mortgage-backed securities, proceeds realized from loans held for sale, brokered
deposits and other wholesale funding.  We also secured federal funds
borrowing lines from three of our correspondent banks.  Two of the
lines are for $15 million each and the other one is for $5
million.  Our banking centers also provide access to retail deposit
markets.  If large certificate depositors shift to our competitors or
other markets in response to interest rate changes, we have the ability to
replenish those deposits through alternative funding
sources.  Traditionally, we have also borrowed from the FHLB to
supplement our funding requirements.  At September 30, 2010, we did
not have sufficient collateral available for additional borrowings from the
FHLB. We believe
we have the ability to raise deposits, when needed, by offering rates at or
slightly above market rates.  If the Bank would fall below
well-capitalized status, we would be subject to wholesale funding restrictions
as well as interest rate restrictions used to attract core
deposits.





At the
holding company level, the Corporation uses cash to pay dividends to
stockholders, repurchase common stock, make selected investments and
acquisitions, and service debt. The main sources of funding for the Corporation
include dividends from the Bank, borrowings and access to the capital
markets.  The Corporation maintains a loan agreement with a
correspondent bank.  As of September 30, 2010, the outstanding balance
of this loan was $345,000.  We subsequently paid this loan off in full
on October 22, 2010, and the loan is now closed.





The
primary source of funding for the Corporation has been dividends and returns of
investment from the Bank. Kentucky banking laws limit the amount of dividends
that may be paid to the Corporation by the Bank without prior approval of the
KDFI.  Under these laws, the amount of dividends that may be paid in
any calendar year is limited to current year’s net income, as defined in the
laws, combined with the retained net income of the preceding two years, less any
dividends declared during those periods.The Bank currently has a
regulatory agreement with the FDIC that requires us to obtain the consent of the
Regional Director of the FDIC and the Commissioner of the KDFI to declare and
pay cash dividends.  The Corporation has also entered into an
agreement with the Federal Reserve to obtain regulatory approval before
declaring any dividends.  We may not redeem shares or obtain
additional borrowings without prior approval.  Because of these
limitations, consolidated cash flows as presented in the consolidated statements
of cash flows may not represent cash immediately available to the
Corporation.  During 2010, the Bank declared and paid dividends of
$587,000 to the Corporation.





CAPITAL





Stockholders’
equity decreased $140,000 for the period ended September 30, 2010 compared to
December 31, 2009 primarily due to a net loss recorded during the
period.  Offsetting this decrease was an increase in unrealized gains
on securities available-for-sale.  Our average stockholders’ equity to
average assets ratio decreased to 6.90% for the nine months ended September 30,
2010 compared to 8.65% for 2009.





On
January 9, 2009, we sold $20 million of cumulative perpetual preferred shares,
with a liquidation preference of $1,000 per share (the “Senior Preferred
Shares”) to the U.S. Treasury under the terms of its Capital Purchase
Program.  The Senior Preferred Shares constitute Tier 1 capital and
rank senior to our common shares.  The Senior Preferred Shares pay
cumulative dividends at a rate of 5% per year for the first five years and will
reset to a rate of 9% per year after five years.





Under the
terms of our CPP stock purchase agreement, we also issued the U.S. Treasury a
warrant to purchase an amount of our common stock equal to 15% of the aggregate
amount of the Senior Preferred Shares, or $3 million.  The warrant
entitles the U.S. Treasury to purchase 215,983 common shares at a purchase price
of $13.89 per share.  The initial exercise price for the warrant and
the number of shares subject to the warrant were determined by reference to the
market price of our common stock calculated on a 20-day trailing average as of
December 8, 2008, the date the U.S. Treasury approved our
application.  The warrant has a term of 10 years and is
potentially dilutive to earnings per share.




38





On
October 29, 2010, we gave written notice to the United States Treasury that we
were suspending the payment of regular quarterly cash dividends on our fixed
rate cumulative perpetual preferred stock, Series A (“Series A Preferred
Stock”).  Since the dividends are cumulative, failure to pay dividends
for six periods would trigger board appointment rights for the holder of the
Series A Preferred Stock.  The dividends will continue to be accrued
for payment in the future and reported as a preferred dividend requirement that
is deducted from income to common shareholders for financial statement
purposes.





The terms
of our Senior Preferred Shares do not allow us to repurchase shares of our
common stock without the consent of the U.S. Treasury until the Senior Preferred
Shares are redeemed.  Additionally, we currently have a regulatory
agreement with the Federal Reserve that requires prior written consent before
repurchasing shares of common stock. During the first nine months of 2010, we
did not purchase any shares of our own common stock.





Each of
the federal bank regulatory agencies has established minimum leverage capital
requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to
adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank
regulatory evaluation of an organization’s overall safety and
soundness.  We intend to maintain a capital position that meets or
exceeds the “well capitalized” requirements established for banks by the
FDIC.  We currently have a regulatory agreement with the FDIC that
requires us to maintain a Tier 1 leverage ratio of 8%.  We currently
are not in compliance with the Tier 1 capital requirement. To achieve the Tier 1
capital requirement that we have agreed to with the FDIC, we plan on raising
additional capital by selling common or preferred stock in the private or public
markets and recapitalizing other elements of our capital structure.





The
following table shows the ratios of Tier 1 capital and total capital to
risk-adjusted assets and the leverage ratios for the Corporation and the Bank as
of September 30, 2010.





To
      Be ConsideredWell
      CapitalizedUnder
      Prompt(Dollars
      in thousands)
              
              
              
              
              
              
              
              For
      Capital
              
              
              CorrectionActual
              
              
              Adequacy
      Purposes
              
              
              Action
      ProvisionsAs
      of September 30, 2010:
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      risk-based capital (to risk-weighted
      assets)Consolidated
              
              $
              112,634
              
              
              
              11.98
              %
              
              $
              75,226
              
              
              
              8.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              112,202
              
              
              
              11.94
              
              
              
              75,171
              
              
              
              8.00
              
              
              
              93,964
              
              
              
              10.00Tier
      I capital (to risk-weightedassets)Consolidated
              
              
              100,777
              
              
              
              10.72
              
              
              
              37,613
              
              
              
              4.00
              
              
              
              N/A
              
              
              
              N/ABank
              
              
              100,344
              
              
              
              10.68
              
              
              
              37,586
              
              
              
              4.00
              
              
              
              56,378
              
              
              
              6.00Tier
      I capital (to average assets)Consolidated
              
              
              100,777
              
              
              
              8.02
              
              
              
              50,249
              
              
              
              4.00
              
              
              
              N/A
              
              
              
              N/ABank
              
              
              100,344
              
              
              
              7.98
              
              
              
              50,297
              
              
              
              4.00
              
              
              
              62,872
              
              
              
              5.00




To
      Be ConsideredWell
      CapitalizedUnder
      Prompt(Dollars
      in thousands)
              
              
              
              
              
              
              
              For
      Capital
              
              
              CorrectionActual
              
              
              Adequacy
      Purposes
              
              
              Action
      ProvisionsAs
      of December 31, 2009:
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              Ratio
              
              
              Amount
              
              
              RatioTotal
      risk-based capital (to risk-weighted
      assets)Consolidated
              
              $
              115,702
              
              
              
              11.35
              %
              
              $
              81,550
              
              
              
              8.00
              %
              
              
              N/A
              
              
              
              N/ABank
              
              
              114,514
              
              
              
              11.25
              
              
              
              81,467
              
              
              
              8.00
              
              
              
              101,834
              
              
              
              10.00Tier
      I capital (to risk-weightedassets)Consolidated
              
              
              102,894
              
              
              
              10.09
              
              
              
              40,775
              
              
              
              4.00
              
              
              
              N/A
              
              
              
              N/ABank
              
              
              101,719
              
              
              
              9.99
              
              
              
              40,734
              
              
              
              4.00
              
              
              
              61,100
              
              
              
              6.00Tier
      I capital (to average assets)Consolidated
              
              
              102,894
              
              
              
              8.66
              
              
              
              47,533
              
              
              
              4.00
              
              
              
              N/A
              
              
              
              N/ABank
              
              
              101,719
              
              
              
              8.90
              
              
              
              45,732
              
              
              
              4.00
              
              
              
              57,165
              
              
              
              5.00




39




Item
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





Asset/Liability
Management and Market Risk





To
minimize the volatility of net interest income and exposure to economic loss
that may result from fluctuating interest rates, we manage our exposure to
adverse changes in interest rates through asset and liability management
activities within guidelines established by our Asset Liability Committee
(“ALCO”).  The ALCO, comprised of senior management representatives,
has the responsibility for approving and ensuring compliance with
asset/liability management policies.  Interest rate risk is the
exposure to adverse changes in the net interest income as a result of market
fluctuations in interest rates.  The ALCO, on an ongoing basis,
monitors interest rate and liquidity risk in order to implement appropriate
funding and balance sheet strategies.  Management considers interest
rate risk to be our most significant market risk.





We
utilize an earnings simulation model to analyze net interest income
sensitivity.  We then evaluate potential changes in market interest
rates and their subsequent effects on net interest income.  The model
projects the effect of instantaneous movements in interest rates of both 100 and
200 basis points.  We also incorporate assumptions based on the
historical behavior of our deposit rates and balances in relation to changes in
interest rates into the model.  These assumptions are inherently
uncertain and, as a result, the model cannot precisely measure future net
interest income or precisely predict the impact of fluctuations in market
interest rates on net interest income.  Actual results will differ
from the model’s simulated results due to timing, magnitude and frequency of
interest rate changes as well as changes in market conditions and the
application and timing of various management strategies.





Our
interest sensitivity profile was asset sensitive at September 30, 2010 and
December 31, 2009.  Given a sustained 100 basis point decrease in
rates, our base net interest income would decrease by an estimated2.81% at September 30,
2010 compared to a decrease of 2.84% at December 31, 2009. Given a 100 basis point
increase in interest rates our base net interest income would increase by
anestimated 1.53%
at September 30, 2010 compared to an increase of 2.70% at December 31,
2009.





We use
various asset/liability strategies to manage the re-pricing characteristics of
our assets and liabilities designed to ensure that exposure to interest rate
fluctuations is limited within our guidelines of acceptable levels of
risk-taking.  As demonstrated by the September 30, 2010 and December
31, 2009 sensitivity tables, our balance sheet has an asset sensitive position.
This means that our earning assets, which consist of loans and investment
securities, will change in price at a faster rate than our deposits and
borrowings.  Therefore, if short term interest rates increase, our net
interest income will increase.  Likewise, if short term interest rates
decrease, our net interest income will decrease.




40





Our
sensitivity to interest rate changes is presented based on data as of September
30, 2010 and December 31, 2009 annualized to a one year period.





September
      30, 2010Decrease
      in Rates
              
              
              
              
              
              Increase
      in Rates200
              
              
              100
              
              
              
              
              
              100
              
              
              200(Dollars
      in thousands)
              
              Basis Points
              
              
              Basis Points
              
              
              Base
              
              
              Basis Points
              
              
              Basis PointsProjected
      interest incomeLoans
              
              $
              51,166
              
              
              $
              52,250
              
              
              $
              53,269
              
              
              $
              54,380
              
              
              $
              55,424Investments
              
              
              5,503
              
              
              
              5,655
              
              
              
              6,251
              
              
              
              6,577
              
              
              
              7,194Total
      interest income
              
              
              56,668
              
              
              
              57,906
              
              
              
              59,520
              
              
              
              60,957
              
              
              
              62,618Projected
      interest expenseDeposits
              
              
              18,733
              
              
              
              18,640
              
              
              
              19,199
              
              
              
              19,972
              
              
              
              20,780Borrowed
      funds
              
              
              2,791
              
              
              
              2,791
              
              
              
              2,790
              
              
              
              2,877
              
              
              
              2,962Total
      interest expense
              
              
              21,524
              
              
              
              21,431
              
              
              
              21,989
              
              
              
              22,850
              
              
              
              23,742Net
      interest income
              
              $
              35,145
              
              
              $
              36,475
              
              
              $
              37,531
              
              
              $
              38,107
              
              
              $
              38,876Change
      from base
              
              $
              (2,386
              )
              
              $
              (1,056
              )
              
              
              
              
              
              $
              576
              
              
              $
              1,345%
      Change from base
              
              
              (6.36
              )%
              
              
              (2.81
              )%
              
              
              
              
              
              
              1.53
              %
              
              
              3.58
              %




December
      31, 2009Decrease
      in Rates
              
              
              
              
              
              Increase
      in Rates200
              
              
              100
              
              
              
              
              
              100
              
              
              200(Dollars
      in thousands)
              
              Basis Points
              
              
              Basis Points
              
              
              Base
              
              
              Basis Points
              
              
              Basis PointsProjected
      interest incomeLoans
              
              $
              55,484
              
              
              $
              56,942
              
              
              $
              58,564
              
              
              $
              60,162
              
              
              $
              61,850Investments
              
              
              2,271
              
              
              
              2,116
              
              
              
              2,150
              
              
              
              2,552
              
              
              
              2,953Total
      interest income
              
              
              57,755
              
              
              
              59,058
              
              
              
              60,714
              
              
              
              62,714
              
              
              
              64,803Projected
      interest expenseDeposits
              
              
              15,938
              
              
              
              16,077
              
              
              
              16,587
              
              
              
              16,920
              
              
              
              18,043Borrowed
      funds
              
              
              3,753
              
              
              
              3,753
              
              
              
              3,752
              
              
              
              4,329
              
              
              
              4,905Total
      interest expense
              
              
              19,691
              
              
              
              19,830
              
              
              
              20,339
              
              
              
              21,249
              
              
              
              22,948Net
      interest income
              
              $
              38,064
              
              
              $
              39,228
              
              
              $
              40,375
              
              
              $
              41,465
              
              
              $
              41,855Change
      from base
              
              $
              (2,311
              )
              
              $
              (1,147
              )
              
              
              
              
              
              $
              1,090
              
              
              $
              1,480%
      Change from base
              
              
              (5.72
              )%
              
              
              (2.84
              )%
              
              
              
              
              
              
              2.70
              %
              
              
              3.67
              %




41




Item
4.  CONTROLS AND PROCEDURES





As of the
end of the period covered by this report, an evaluation was carried out by our
management, with the participation of our Chief Executive Officer and Chief
Financial Officer, of the effectiveness of our disclosure controls and
procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of
1934). Based upon that evaluation, the Company’s Chief Executive Officer and
Chief Financial Officer concluded that these disclosure controls and procedures
were effective as of the end of the period covered by this report. In addition,
no change in the Company’s internal control over financial reporting (as defined
in Rule 13a-15(f) under the Securities Exchange Act of 1934) occurred during the
fiscal quarter covered by this report that has materially affected, or is
reasonably likely to materially affect, the Company’s internal control over
financial reporting.





Part
II - OTHER INFORMATION





Item
      1.
            Legal
      Proceedings





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


Item
      1A.
              Risk
      Factors


Information
regarding risks that could materially affect our business, financial condition
or future results appear in our Annual Report on Form 10-K for the year ended
December 31, 2009 under Item 1A – Risk Factors.  In addition, you
should carefully consider the following supplemental risk
factor.





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





Future
sales of stock could dilute our equity, which may adversely affect the market
price of our common stock.





From time
to time, we evaluate raising capital through the sale of
securities.  We are not restricted from issuing additional common
stock, including securities that are convertible into or exchangeable for, or
that represent the right to receive, common stock.  The issuance of
additional shares of common stock or the issuance of convertible securities
would dilute the ownership interest of our existing common shareholders. The
market price of our common stock could decline as a result of such an offering
as well as other sales of a large block of shares of our common stock or similar
securities in the market after an offering, or the perception that such sales
could occur.





The impact of financial reform
legislation on us is uncertain.




The
recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act
institutes a wide range of reforms that will have an impact on all financial
institutions.  Changes to the deposit insurance and financial
regulatory systems, enhanced bank capital requirements and new regulations
designed to protect consumers in financial transactions are only a few of the
provisions of the Act.  Many of these provisions are subject to rule
making procedures and studies that will be conducted in the
future.  Accordingly, we cannot assess the impact the Act will have on
us at the present time.
  We
are not paying cash dividends on our common and preferred stock and are
deferring interest payments on the junior subordinated debentures that relate to
our trust preferred securities, and we are restricted in our ability to resume
such payments. The failure to resume paying dividends and distributions on our
securities may adversely affect us.
 
 We
historically paid cash dividends on our common stock before we suspended them in
December 2009. Subsequently, we also suspended cash dividends on the Treasury
Preferred Stock and began deferring interest payments on the junior subordinated
notes relating to our trust preferred securities. Deferring interest payments on
the junior subordinated notes will result in a deferral of distributions on our
trust preferred securities. Future payment of cash dividends on our common stock
will be subject to the prior payment of all unpaid dividends on the Treasury
Preferred Stock and all deferred distributions on our trust preferred
securities. If we miss six quarterly dividend payments on the Treasury Preferred
Stock, whether or not consecutive, the Treasury Department will have the right
to appoint two directors to our board of directors until all accrued but unpaid
dividends have been paid. Dividends on the Treasury Preferred Stock and deferred
distributions on our trust preferred securities are cumulative and therefore
unpaid dividends and distributions will accrue and compound on each subsequent
payment date. In the event we become subject to any liquidation, dissolution or
winding up of affairs, holders of the trust preferred securities and then
holders of the preferred stock will be entitled to receive the liquidation
amounts they are entitled to plus the amount of any accrued and unpaid
distributions and dividends, before any distribution to the holders of common
stock.
 
 Future
sales of our common stock or other securities will dilute the ownership
interests of our existing shareholders and could depress the market price of our
common stock.
  We are
currently evaluating strategies to meet our capital needs and regulatory
requirements.  These strategies may result in the issuance of
additional common stock.  We can issue stock without shareholder
approval, up to the number of authorized shares set forth in our Amended and
Restated Articles of Incorporation, as amended (the “Articles of
Incorporation”). Our Board of Directors may determine from time to time a need
to obtain additional capital through the issuance of additional shares of common
stock or other preferred securities including securities convertible into or
exchangeable for shares of our common stock, subject to limitations imposed by
Nasdaq and the Federal Reserve. There can be no assurance that such shares can
be issued at prices or on terms better than or equal to the terms obtained by
our current shareholders. The issuance of any additional shares of common stock
or convertible or exchangeable preferred securities by us in the future may
result in a reduction of the book value or market price, if any, of the
then-outstanding common stock. Issuance of additional shares of common stock or
convertible or exchangeable preferred securities will reduce the proportionate
ownership and voting power of our existing shareholders.
  In
addition, sales of a substantial number of shares of our common stock or
convertible or exchangeable preferred securities in the public market by our
shareholders, or the perception that such sales are likely to occur, could cause
the market price of our common stock to decline. We cannot predict the effect,
if any, that future sales of our common stock in the market, or availability of
shares of our common stock for sale in the market, will have on the market price
of our common stock. We therefore can give no assurance sales of substantial
amounts of our common stock in the market, or the potential for large amounts of
sales in the market, would not cause the price of our common stock to decline or
impair our ability to raise capital through sales of our common
stock.
  We cannot
guarantee whether such financing will be available to us on acceptable terms or
at all. If we are unable to obtain future financing, we may not have the capital
and financial resources we require for our business or that are necessary to
meet regulatory requirements.


42




Item
      2.
              Unregistered
      Sales of Securities and Use of
Proceeds


We did
not repurchase any shares of our common stock during the quarter ended September
30, 2010.


Item
      3.
              Defaults
      Upon Senior Securities
 Not
Applicable


Item
      4.
              Reserved


Item
      5.
              Other
      Information
  None


Item
      6.
              Exhibits:


31.1
              Certification
      of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley
      Act31.2
              Certification
      of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley
      Act32
              Certification
      of Chief Executive Officer and Chief Financial Officer Pursuant to Section
      18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002)




43




FIRST
FINANCIAL SERVICE CORPORATION





SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.


Date:  November
      9, 2010
            By:
            /s/  B.
      Keith JohnsonB.
      Keith JohnsonChief
      Executive OfficerDate:  November
      9, 2010
            By:
            /s/
      Steven M. ZagarSteven
      M. ZagarChief
      Financial Officer &Principal
      Accounting Officer




44




INDEX
TO EXHIBITS





Exhibit No.
            
            Description31.1
            
            Certification
      of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley
      Act31.2
            
            Certification
      of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley
      Act32
            
            Certification
      of Chief Executive Officer and Chief Financial Officer Pursuant to 18
      U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002)




45