Table of Contents

 

 

 

**UNITEDSTATES**

**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,  2008** |
| ** **                                                  | ** **                                                                                               |
| **OR**                                                      |
|                                                        |                                                                                                     |
| **o**                                                       | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |

** **

**Commission File Number0-18832**

** **

**First Financial Service Corporation**

(Exact Name of Registrant asspecified in its charter)

 

| **Kentucky**                      |   | **61-1168311**                    |
|-----------------------------------|--------|-----------------------------------|
| (State or other jurisdiction      |   | (IRS Employer Identification No.) |
| of incorporation or organization) |   |                              |

 

**2323 RingRoad**

**Elizabethtown,Kentucky  42701**

(Address of principalexecutive offices)

(Zip Code)

 

**(270) 765-2131**

(Registrant’s telephone number, includingarea code)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.   Yes x No o

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, a non-accelerated filer, or asmaller reporting company.  Seedefinition of “accelerated filer”, “large accelerated filer” and “smallerreporting 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)         |                         |

 

Indicateby a check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).  Yes o No x

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

| **Class**    | ** ** | **Outstanding as of October 31, 2008** |
|--------------|------------|-----------------------------------------------------------------|
| ** **   | ** ** | ** **                                                      |
| Common Stock |       | 4,668,030 shares                                                |

** **

 

** **

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Tableof Contents

 

## **FIRST FINANCIAL SERVICECORPORATION**

**FORM 10-Q**

**TABLE OFCONTENTS**

 
| **PART I** – **FINANCIAL  INFORMATION**      |                                                                                        |
|--------------------------------------------------------|---------------------------------------------------------------------------------------------|
| ** **                                             |                                                                                        |
| Preliminary Note Regarding  Forward-Looking Statements |                                                                                        |
|                                                   |                                                                                        |   |
| **Item 1.**                                            | Consolidated Financial Statements and Notes  to Consolidated Financial Statements           |   |
|                                                   |                                                                                        |   |
| **Item 2.**                                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|                                                   |                                                                                        |   |
| **Item 3.**                                            | Quantitative  and Qualitative Disclosures about Market Risk                                 |   |
|                                                   |                                                                                        |   |
| **Item 4.**                                            | Controls and  Procedures                                                                    |   |
|                                                   |                                                                                        |   |
| **PART II–  OTHER INFORMATION**              |                                                                                        |
|                                                   |                                                                                        |   |
| **Item 1.**                                            | Legal Proceedings                                                                           |   |
|                                                   |                                                                                        |   |
| **Item 1A.**                                           | Risk Factors                                                                                | ** ** |
| ** **                                             | ** **                                                                                  | ** ** |
| **Item 2.**                                            | Unregistered Sales of Equity Securities and Use of Proceeds                                 |   |
|                                                   |                                                                                        |   |
| **Item 3.**                                            | Defaults upon Senior Securities                                                             |   |
|                                                   |                                                                                        |   |
| **Item 4.**                                            | Submission of Matters to a Vote of Security Holders                                         |   |
|                                                   |                                                                                        |   |
| **Item 5.**                                            | Other Information                                                                           |   |
|                                                   |                                                                                        |   |
| **Item 6.**                                            | Exhibits                                                                                    |   |
| ** **                                             |                                                                                        |   |
| **SIGNATURES**                                         |                                                                                        |

 

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### **PRELIMINARYNOTE REGARDING**

### **FORWARD-LOOKINGSTATEMENTS**

### ** **

Statementsin this report that are not statements of historical fact are forward-lookingstatements. First Financial Service Corporation (the “Corporation”) may makeforward-looking statements in future filings with the Securities and ExchangeCommission (“SEC”), in press releases, and in oral and written statements madeby or with the approval of the Corporation. Forward-looking statements include, but are not limited to: (1) projectionsof revenues, income or loss, earnings or loss per share, capital structure andother financial items; (2) plans and objectives of the Corporation or itsmanagement or Board of Directors; (3) statements regarding future events,actions or economic performance; and (4) statements of assumptionsunderlying such statements.  Words suchas “estimate,” “strategy,” “believes,” “anticipates,” “expects,” “intends,” “plans,”“targeted,” and similar expressions are intended to identify forward-lookingstatements, but are not the exclusive means of identifying such statements.

 

Various risks and uncertainties may cause actual results todiffer materially from those indicated by our forward-looking statements.  In addition to those risks described under “Item1A Risk Factors,” of this report and our Annual Report on Form 10-K, thefollowing factors could cause such differences: changes in general economicconditions and economic conditions in Kentucky and the markets we serve, any ofwhich may affect, among other things, our level of non-performing assets,charge-offs, and provision for loan loss expense; changes in interest ratesthat may reduce interest margins and impact funding sources; changes in marketrates and prices which may adversely impact the value of financial productsincluding securities, loans and deposits; changes in tax laws, rules andregulations; various monetary and fiscal policies and regulations, includingthose determined by the Federal Reserve Board, the Federal Deposit InsuranceCorporation (“FDIC”) and the Kentucky Office of Financial Institutions (“KOFI”);competition with other local and regional commercial banks, savings banks,credit unions and other non-bank financial institutions; our ability to growcore businesses; our ability to develop and introduce new banking-relatedproducts, services and enhancements and gain market acceptance of suchproducts; and management’s ability to manage these and other risks.

 

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

 

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| **Item  1.** | ** ** | **FIRST  FINANCIAL SERVICE CORPORATION** |
|--------------|------------|------------------------------------------|
| ** **   | ** ** | **Consolidated  Balance Sheets**         |
| ** **   | ** ** | **(Unaudited)**                          |

** **
| ** **                                                                                                                                                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(Dollars in thousands, except share data)**                                                                                      | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                                                                                                                  | ** ** | ** **             | ** ** | ** **            | ** ** |
| **ASSETS:**                                                                                                                                                 |       |                   |       |                  |       |
| Cash and due  from banks                                                                                                                                    |       | $                      | 27,079     |                  | $          | 14,948 |   |
| Federal funds  sold                                                                                                                                         |       | 4,600                  |       | —                |       |
| Cash and cash  equivalents                                                                                                                                  |       | 31,679                 |       | 14,948                |       |
|                                                                                                                                                        |       |                   |       |                  |       |
| Securities  available-for-sale                                                                                                                              |       | 17,119                 |       | 22,004                |       |
| Securities  held-to-maturity, fair value of $7,583 (Sept 2008) and $17,624 (Dec 2007)                                                                       |       | 7,658                  |       | 17,681                |       |
| Total securities                                                                                                                                            |       | 24,777                 |       | 39,685                |       |
|                                                                                                                                                        |       |                   |       |                  |       |
| Loans held for  sale                                                                                                                                        |       | 2,191                  |       | 780                   |       |
| Loans, net of  unearned fees                                                                                                                                |       | 870,294                |       | 767,256               |       |
| Allowance for  loan losses                                                                                                                                  |       | (10,508                | )          | (7,922                | )          |
| Net loans                                                                                                                                                   |       | 861,977                |       | 760,114               |       |
|                                                                                                                                                        |       |                   |       |                  |       |
| Federal Home  Loan Bank stock                                                                                                                               |       | 8,515                  |       | 7,621                 |       |
| Cash surrender  value of life insurance                                                                                                                     |       | 8,561                  |       | 8,290                 |       |
| Premises and  equipment, net                                                                                                                                |       | 30,246                 |       | 26,335                |       |
| Real estate  owned:                                                                                                                                         |       |                   |       |                  |       |
| Acquired through  foreclosure                                                                                                                               |       | 5,649                  |       | 1,749                 |       |
| Held for  development                                                                                                                                       |       | 45                     |       | 45                    |       |
| Other  repossessed assets                                                                                                                                   |       | 91                     |       | 52                    |       |
| Goodwill                                                                                                                                                    |       | 12,166                 |       | 8,384                 |       |
| Core deposit  intangible                                                                                                                                    |       | 1,851                  |       | —                |       |
| Accrued interest  receivable                                                                                                                                |       | 4,169                  |       | 4,324                 |       |
| Other assets                                                                                                                                                |       | 1,549                  |       | 1,144                 |       |
|                                                                                                                                                        |       |                   |       |                  |       |
| **TOTAL  ASSETS**                                                                                                                                           |       | $                      | 991,275    |                  | $          | 872,691 |   |
|                                                                                                                                                        |       |                   |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                              |       |                   |       |                  |       |
| **LIABILITIES:**                                                                                                                                            |       |                   |       |                  |       |
| Deposits:                                                                                                                                                   |       |                   |       |                  |       |
| Non-interest  bearing                                                                                                                                       |       | $                      | 63,051     |                  | $          | 46,978 |   |
| Interest bearing                                                                                                                                            |       | 713,870                |       | 642,265               |       |
| Total deposits                                                                                                                                              |       | 776,921                |       | 689,243               |       |
|                                                                                                                                                        |       |                   |       |                  |       |
| Short-term  borrowings                                                                                                                                      |       | 65,300                 |       | 42,800                |       |
| Advances from  Federal Home Loan Bank                                                                                                                       |       | 52,981                 |       | 53,083                |       |
| Subordinated  debentures                                                                                                                                    |       | 18,000                 |       | 10,000                |       |
| Accrued interest  payable                                                                                                                                   |       | 458                    |       | 1,093                 |       |
| Accounts payable  and other liabilities                                                                                                                     |       | 2,036                  |       | 1,789                 |       |
| Deferred income  taxes                                                                                                                                      |       | 1,123                  |       | 1,223                 |       |
|                                                                                                                                                        |       |                   |       |                  |       |
| **TOTAL  LIABILITIES**                                                                                                                                      |       | 916,819                |       | 799,231               |       |
| Commitments and  contingent liabilities                                                                                                                     |       | —                 |       | —                |       |
|                                                                                                                                                        |       |                   |       |                  |       |
| **STOCKHOLDERS’  EQUITY:**                                                                                                                             |       |                   |       |                  |       |
| Serial preferred  stock, 5,000,000 shares authorized and unissued                                                                                           |       | —                 |       | —                |       |
| Common stock, $1  par value per share; authorized 10,000,000 shares; issued and outstanding,  4,668,030 shares (Sept 2008), and 4,661,083 shares (Dec 2007) |       | 4,668                  |       | 4,661                 |       |
| Additional  paid-in capital                                                                                                                                 |       | 34,115                 |       | 33,886                |       |
| Retained  earnings                                                                                                                                          |       | 37,539                 |       | 35,225                |       |
| Accumulated  other comprehensive loss                                                                                                                       |       | (1,866                 | )          | (312                  | )          |
|                                                                                                                                                        |       |                   |       |                  |       |
| **TOTAL  STOCKHOLDERS’ EQUITY**                                                                                                                        |       | 74,456                 |       | 73,460                |       |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                        |       | $                      | 991,275    |                  | $          | 872,691 |   |

 

*Seenotes to the unaudited consolidated financial statements.*

 

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| **FIRST  FINANCIAL SERVICE CORPORATION** |
|------------------------------------------|
| **Consolidated  Statements of Income**   |
| **(Unaudited)**                          |

 
| ** **                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **(Dollars in thousands, except per share data)** | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                                      |       |                             |       |                            |       |   |   |   |   |
| **Interest  and Dividend Income:**                                              |       |                             |       |                            |       |   |   |   |   |
| Loans, including  fees                                                          |       | $                                | 14,337     |                            | $          | 14,760 |   | $ | 41,718 |   | $ | 43,065 |   |
| Taxable  securities                                                             |       | 403                              |       | 490                             |       | 1,095 |   | 1,638 |   |
| Tax exempt  securities                                                          |       | 90                               |       | 102                             |       | 297 |   | 317 |   |
| Total interest  income                                                          |       | 14,830                           |       | 15,352                          |       | 43,110 |   | 45,020 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| **Interest  Expense:**                                                          |       |                             |       |                            |       |   |   |   |   |
| Deposits                                                                        |       | 5,325                            |       | 6,695                           |       | 15,815 |   | 19,082 |   |
| Short-term  borrowings                                                          |       | 156                              |       | 465                             |       | 661 |   | 1,452 |   |
| Federal Home  Loan Bank advances                                                |       | 610                              |       | 345                             |       | 1,808 |   | 1,022 |   |
| Subordinated  debentures                                                        |       | 315                              |       | 167                             |       | 649 |   | 549 |   |
| Total interest  expense                                                         |       | 6,406                            |       | 7,672                           |       | 18,933 |   | 22,105 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Net interest  income                                                            |       | 8,424                            |       | 7,680                           |       | 24,177 |   | 22,915 |   |
| Provision for  loan losses                                                      |       | 1,720                            |       | 740                             |       | 2,819 |   | 948 |   |
| Net interest  income after provision for loan losses                            |       | 6,704                            |       | 6,940                           |       | 21,358 |   | 21,967 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| **Non-interest  Income:**                                                       |       |                             |       |                            |       |   |   |   |   |
| Customer service  fees on deposit accounts                                      |       | 1,817                            |       | 1,511                           |       | 4,865 |   | 4,274 |   |
| Gain on sale of  mortgage loans                                                 |       | 179                              |       | 144                             |       | 566 |   | 435 |   |
| Gain on sale of  investments                                                    |       | 52                               |       | —                          |       | 52 |   | — |   |
| Gain on sale of  real estate held for development                               |       | —                           |       | —                          |       | — |   | 227 |   |
| Losses on securities  transactions                                              |       | —                           |       | —                          |       | (216 | ) | — |   |
| Write down on  real estate acquired through foreclosure                         |       | (151                             | )          | —                          |       | (160 | ) | — |   |
| Brokerage  commissions                                                          |       | 109                              |       | 106                             |       | 352 |   | 308 |   |
| Other income                                                                    |       | 361                              |       | 444                             |       | 1,001 |   | 945 |   |
| Total  non-interest income                                                      |       | 2,367                            |       | 2,205                           |       | 6,460 |   | 6,189 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| **Non-interest  Expense:**                                                      |       |                             |       |                            |       |   |   |   |   |
| Employee  compensation and benefits                                             |       | 3,867                            |       | 3,136                           |       | 10,765 |   | 9,365 |   |
| Office occupancy  expense and equipment                                         |       | 779                              |       | 604                             |       | 2,112 |   | 1,766 |   |
| Marketing and  advertising                                                      |       | 215                              |       | 228                             |       | 638 |   | 677 |   |
| Outside services  and data processing                                           |       | 882                              |       | 638                             |       | 2,365 |   | 1,974 |   |
| Bank franchise  tax                                                             |       | 258                              |       | 234                             |       | 761 |   | 699 |   |
| Write off of  issuance cost of Trust Preferred Securities                       |       | —                           |       | —                          |       | — |   | 229 |   |
| Amortization of  core deposit intangible                                        |       | 56                               |       | —                          |       | 59 |   | — |   |
| Other expense                                                                   |       | 1,580                            |       | 1,166                           |       | 3,791 |   | 3,112 |   |
| Total  non-interest expense                                                     |       | 7,637                            |       | 6,006                           |       | 20,491 |   | 17,822 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Income before  income taxes                                                     |       | 1,434                            |       | 3,139                           |       | 7,327 |   | 10,334 |   |
| Income taxes                                                                    |       | 443                              |       | 1,008                           |       | 2,354 |   | 3,343 |   |
| **Net  Income**                                                                 |       | $                                | 991        |                            | $          | 2,131 |   | $ | 4,973 |   | $ | 6,991 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Shares  applicable to basic income per share                                    |       | 4,667,081                        |       | 4,681,582                       |       | 4,665,058 |   | 4,739,352 |   |
| **Basic  income per share**                                                     |       | $                                | 0.21       |                            | $          | 0.46 |   | $ | 1.07 |   | $ | 1.48 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Shares  applicable to diluted income per share                                  |       | 4,683,978                        |       | 4,731,496                       |       | 4,689,458 |   | 4,792,560 |   |
| **Diluted  income per share**                                                   |       | $                                | 0.21       |                            | $          | 0.45 |   | $ | 1.06 |   | $ | 1.46 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| **Cash  dividends declared per share**                                          |       | $                                | 0.190      |                            | $          | 0.190 |   | $ | 0.570 |   | $ | 0.536 |   |

 

*Seenotes to the unaudited consolidated financial statements.*

 

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Comprehensive Income/Loss**

**(Unaudited)**

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **(Dollars in thousands)**                               | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| **Net  Income**                                                    |       | $                                | 991        |                            | $          | 2,131 |   | $ | 4,973 |   | $ | 6,991 |   |
| Other  comprehensive income (loss):                                |       |                             |       |                            |       |   |   |   |   |
| Change in  unrealized gain (loss) on securities available-for-sale |       | (2,131                           | )          | 364                             |       | (2,518 | ) | (196 | ) |
| Reclassification  of realized amount                               |       | (52                              | )          | —                          |       | 164 |   | — |   |
| Net unrealized  gain (loss) recognized in comprehensive income     |       | (2,183                           | )          | 364                             |       | (2,354 | ) | (196 | ) |
| Tax effect                                                         |       | 742                              |       | (124                            | )          | 800 |   | 66 |   |
| Total other  comphrehensive income (loss)                          |       | (1,441                           | )          | 240                             |       | (1,554 | ) | (130 | ) |
|                                                               |       |                             |       |                            |       |   |   |   |   |
| **Comprehensive  Income (Loss)**                                   |       | $                                | (450       | )                               | $          | 2,371 |   | $ | 3,419 |   | $ | 6,861 |   |

 

*Seenotes to the unaudited consolidated financial statements.*

## ** **

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatement of Changes in Stockholders’ Equity**

**NineMonths Ended September 30, 2008**

**(DollarsIn Thousands, Except Per Share Amounts)**

**(Unaudited)**

 
| ** **                                                                            | ** ** | **Common Stock** | ** ** | **Additional  Paid-in** | ** ** | **Retained** | ** ** | **Accumulated  Other  Comprehensive  (Loss), Net of** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|--------------|------------|-----------------------------------------------------------------|------------|------------|------------|
| ** **                                                                            | ** ** | **Shares**            | ** ** | **Amount**              | ** ** | **Capital**  | ** ** | **Earnings**                                                    | ** ** | **Tax**    | ** ** | **Total** | ** ** |
|                                                                                  |       |                  |       |                    |       |         |       |                                                            |       |       |       |   |   |
| **Balance,  January 1, 2008**                                                    |       | 4,661                 |       | $                       | 4,661      |         | $          | 33,886                                                          |       | $          | 35,225     |   | $ | (312 | ) | $ | 73,460 |   |
| Net income                                                                            |       |                  |       |                    |       |         |       | 4,973                                                           |       |       |       | 4,973 |   |
| Stock issued for  employee benefit plans                                              |       | 7                     |       | 7                       |       | 137          |       |                                                            |       |       |       | 144 |   |
| Stock-based  compensation expense                                                     |       |                  |       |                    |       | 92           |       |                                                            |       |       |       | 92 |   |
| Net change in  unrealized gains (losses) on securities available-for-sale, net of tax |       |                  |       |                    |       |         |       |                                                            |       | (1,554     | )          | (1,554 | ) |
| Cash dividends  declared ($.57 per share)                                             |       | —                |       | —                  |       | —       |       | (2,659                                                          | )          | —     |       | (2,659 | ) |
| **Balance,  September 30, 2008**                                                 |       | 4,668                 |       | $                       | 4,668      |         | $          | 34,115                                                          |       | $          | 37,539     |   | $ | (1,866 | ) | $ | 74,456 |   |

 

*Seenotes to the unaudited consolidated financial statements.*

 

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**FIRST FINANCIAL SERVICE CORPORATION**

**Consolidated Statements of Cash Flows**

**(Dollars In Thousands)**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**          | ** ** |
| ** **                                                                         | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| **Operating  Activities:**                                                         |       |                            |       |   |   |
| Net income                                                                         |       | $                               | 4,973      |   | $ | 6,991 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                            |       |   |   |
| Provision for  loan losses                                                         |       | 2,819                           |       | 948 |   |
| Depreciation on  premises and equipment                                            |       | 1,178                           |       | 1,076 |   |
| Federal Home  Loan Bank stock dividends                                            |       | (309                            | )          | — |   |
| Core deposit  intangible amortization                                              |       | 59                              |       | — |   |
| Net amortization  (accretion) available-for-sale                                   |       | (3                              | )          | (1 | ) |
| Net amortization  (accretion) held-to-maturity                                     |       | 18                              |       | 16 |   |
| Impairment loss  on securities                                                     |       | 216                             |       | — |   |
| Gain on sale of  investments available-for-sale                                    |       | (52                             | )          | — |   |
| Gain on sale of  real estate held for development                                  |       | —                          |       | (227 | ) |
| Gain on sale of  mortgage loans                                                    |       | (566                            | )          | (435 | ) |
| Origination of  loans held for sale                                                |       | (47,277                         | )          | (25,778 | ) |
| Proceeds on sale  of loans held for sale                                           |       | 46,432                          |       | 25,479 |   |
| Stock-based  compensation expense                                                  |       | 92                              |       | 76 |   |
| Changes in:                                                                        |       |                            |       |   |   |
| Cash surrender  value of life insurance                                            |       | (271                            | )          | (249 | ) |
| Interest  receivable                                                               |       | 155                             |       | (170 | ) |
| Other assets                                                                       |       | (17                             | )          | (5 | ) |
| Interest payable                                                                   |       | (763                            | )          | 767 |   |
| Accounts payable  and other liabilities                                            |       | (589                            | )          | 255 |   |
| Net cash from  operating activities                                                |       | 6,095                           |       | 8,743 |   |
|                                                                               |       |                            |       |   |   |
| **Investing  Activities:**                                                         |       |                            |       |   |   |
| Cash paid for  acquisition of Farmers State Bank, net of cash acquired             |       | (1,466                          | )          | — |   |
| Sales of  securities available-for-sale                                            |       | 679                             |       | — |   |
| Purchases of  securities available-for-sale                                        |       | (524                            | )          | (395 | ) |
| Maturities of  securities available-for-sale                                       |       | 2,208                           |       | 5,663 |   |
| Maturities of  securities held-to-maturity                                         |       | 12,517                          |       | 3,747 |   |
| Net change in  loans                                                               |       | (58,518                         | )          | (64,083 | ) |
| Net purchases of  premises and equipment                                           |       | (4,070                          | )          | (4,010 | ) |
| Sales of real  estate for development                                              |       | —                          |       | 473 |   |
| Net cash from  investing activities                                                |       | (49,174                         | )          | (58,605 | ) |
|                                                                               |       |                            |       |   |   |
| **Financing  Activities**                                                          |       |                            |       |   |   |
| Net change in  deposits                                                            |       | 31,927                          |       | 55,567 |   |
| Change in  short-term borrowings                                                   |       | 22,500                          |       | (300 | ) |
| Repayments to  Federal Home Loan Bank                                              |       | (102                            | )          | (106 | ) |
| Proceeds from  issuance of subordinated debentures                                 |       | 8,000                           |       | 10,000 |   |
| Payoff of  subordinated debentures                                                 |       | —                          |       | (10,000 | ) |
| Issuance of  common stock for employee benefit plans                               |       | 144                             |       | 175 |   |
| Dividends paid                                                                     |       | (2,659                          | )          | (2,535 | ) |
| Common stock  repurchased                                                          |       | —                          |       | (4,366 | ) |
| Net cash from  financing activities                                                |       | 59,810                          |       | 48,435 |   |
|                                                                               |       |                            |       |   |   |
| **(Decrease)  Increase in cash and cash equivalents**                              |       | 16,731                          |       | (1,427 | ) |
| **Cash  and cash equivalents, beginning of period**                                |       | 14,948                          |       | 19,082 |   |
| **Cash  and cash equivalents, end of period**                                      |       | $                               | 31,679     |   | $ | 17,655 |   |

 

*Seenotes to the unaudited consolidated financial statements.*

*SeeNote 7 regarding non-cash transactions included in the acquisition.*

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****                                     ****BASIS OF PRESENTATION ANDSUMMARY 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 two wholly owned subsidiaries, First Service Corporation of Elizabethtown 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 wholly-owned subsidiary.  All significant intercompany transactions and balances have been eliminated in consolidation.

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with U.S. generally accepted accounting principles for interimfinancial information and with the instructions to Form 10-Q and Rule 10-01of Regulation S-X.  Accordingly, they donot include all of the information and footnotes required by U.S. generallyaccepted accounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included.  Operatingresults for the three and nine month periods ending September 30, 2008 arenot necessarily indicative of the results that may occur for the year ending December 31,2008.  For further information, refer tothe consolidated financial statements and footnotes thereto included in theCorporation’s annual report on Form 10-K for the period ended December 31,2007.

 

***Adoption of New Accounting Standards –*** We adopted the provisions of SFAS No. 157,“Fair Value Measurements” (“SFAS No. 157”) on January 1, 2008.  SFAS No. 157 defines fair value,establishes a framework for measuring fair value in U.S. generally acceptedaccounting principles (U.S. GAAP), and expands disclosures about fair valuemeasurements.  More specifically, thisstatement clarifies the definition of fair value, establishes a fair valuationhierarchy based upon observable (e.g. quoted prices, interest rates, yieldcurves) and unobservable market inputs, and expands disclosure requirements toinclude the inputs used to develop estimates of fair value and the effects ofthe estimates on income for the period. This statement does not require any newfair value measurements.  For furtherinformation, see Note 6.

 

In February 2008, theFASB issued Staff Position (FSP) 157-2, Effective Date of FASB Statement No. 157.  This FSP delays the effective date of FAS157  for all nonfinancial assets andnonfinancial liabilities, except those that are recognized or disclosed at fairvalue on a recurring basis (at least annually) to fiscal years beginning after November 15,2008, and interim periods within those fiscal years.

 

In February 2007, theFASB issued SFAS 159, “The Fair ValueOption for Financial Assets and Financial Liabilities — Including an amendmentof FASB Statement No. 115.”****Thisstatement allows companies to record certain financial assets and financialliabilities at full fair value if they so choose. The statement was issued tomitigate volatility in reported earnings caused by an accounting modelutilizing multiple measurement attributes. The adoption of the fair valueoption is recorded as a cumulative-effect adjustment to the opening balance ofretained earnings, which would be January 1, 2008. Upon adoption, thedifference between the carrying amount and the fair value of the items chosenis removed from the balance sheet and included in the cumulative-effect adjustment.Subsequent changes in fair value are recorded through the income statement. Wedid not elect the fair value option for any financial assets or financialliabilities as of January 1, 2008 or subsequently.

 

In September 2006, theFASB Emerging Issues Task Force finalized Issue No. 06-4, “Accounting forDeferred Compensation and Postretirement Benefit Aspects of EndorsementSplit-Dollar Life Insurance Arrangements.” This issue requires that a liability be recorded during the serviceperiod when a split-dollar life insurance agreement continues afterparticipants’ employment or retirement. The required accrued liability will be based on either thepost-employment benefit cost for the continuing life insurance or based on thefuture death benefit depending on the contractual terms of the underlyingagreement.  This issue is effective forfiscal years beginning after December 15, 2007.  The impact of adoption was not material.

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

***RecentAccounting Pronouncements –*** In December 2007, the FASB issued SFAS 141 (revised 2007), *Business Combinations*(*SFAS 141R*). SFAS 141R establishesprinciples and requirements for how the acquirer of a business recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any non-controlling interest in the acquiree. SFAS 141Ralso provides guidance for recognizing and measuring the goodwill acquired inthe business combination and determines what information to disclose to enableusers of the financial statements to evaluate the nature and financial effectsof the business combination. SFAS 141R is effective for business combinationswhere the acquisition date is on or after fiscal years beginning after December 15,2008. SFAS******141R isexpected to have an impact on our accounting for any business combinationsclosing on or after January 1, 2009.

 

In December 2007, theFASB issued SFAS 160, *Non-controllingInterests in Consolidated Financial Statements– an amendment of ARB No. 51(SFAS 160)*. SFAS 160 establishes accounting and reporting standardsfor the non-controlling interest in a subsidiary and for the deconsolidation ofa subsidiary. SFAS 160 clarifies that a non-controlling interest in asubsidiary is an ownership interest in the consolidated entity that should bereported as equity in the consolidated financial statements and requiresretroactive adoption of the presentation and disclosure requirements forexisting minority interests. All other requirements of SFAS 160 shall beapplied prospectively. SFAS 160 is effective for fiscal year beginning after December 15,2008.

 

In October 2008, the FASB issued FSP No. 157-3, *Determining the Fair Value of a Financial Asset When the Market forthat Asset Is Not Active.*The FSP clarifies the application of SFAS157 in a market that is not active and provides an example to illustrate keyconsideration in determining the fair value of a financial asset when themarket for that financial asset is not active.

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**2.**             **SECURITIES**

 

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

 
| ** **                           | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|--------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                           | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
| **(Dollars in thousands)** | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| **Securities  available-for-sale:**  |       |          |       |           |       |           |       |                |       |
| **September 30,  2008:**        |       |          |       |           |       |           |       |                |       |
| Mortgage-backed                      |       | $             | 6,383      |           | $          | 28             |       | $                   | (15        | ) | $ | 6,396 |   |
| Equity                               |       | 1,233         |       | 18             |       | (46            | )          | 1,205               |       |
| State and municipal                  |       | 9,608         |       | 3              |       | (805           | )          | 8,806               |       |
| Corporate                            |       | 2,728         |       | —         |       | (2,016         | )          | 712                 |       |
|                                 |       |          |       |           |       |           |       |                |       |
| Total                                |       | $             | 19,952     |           | $          | 49             |       | $                   | (2,882     | ) | $ | 17,119 |   |
|                                 |       |          |       |           |       |           |       |                |       |
| **December 31,  2007:**         |       |          |       |           |       |           |       |                |       |
| U.S. Treasury and  agencies          |       | $             | 498        |           | $          | 3              |       | $                   | —     |   | $ | 501 |   |
| Mortgage-backed                      |       | 7,624         |       | 5              |       | (53            | )          | 7,576               |       |
| Equity                               |       | 1,553         |       | 324            |       | (355           | )          | 1,522               |       |
| State and municipal                  |       | 9,994         |       | 4              |       | (400           | )          | 9,598               |       |
| Corporate                            |       | 2,807         |       | —         |       | —         |       | 2,807               |       |
|                                 |       |          |       |           |       |           |       |                |       |
| Total                                |       | $             | 22,476     |           | $          | 336            |       | $                   | (808       | ) | $ | 22,004 |   |

 
| ** **                        | ** ** | ** **    | ** ** | **Gross**        | ** ** | **Gross**        | ** ** | ** **          | ** ** |
|-----------------------------------|------------|---------------|------------|------------------|------------|------------------|------------|---------------------|------------|
| ** **                        | ** ** | **Amortized** | ** ** | **Unrecognized** | ** ** | **Unrecognized** | ** ** | ** **          | ** ** |
| ** **                        | ** ** | **Cost**      | ** ** | **Gains**        | ** ** | **Losses**       | ** ** | **Fair Value** | ** ** |
| **Securities  held-to-maturity:** |       |          |       |             |       |             |       |                |       |
| **September 30,  2008:**     |       |          |       |             |       |             |       |                |       |
| U.S. Treasury and  agencies       |       | $             | 5,008      |             | $          | 35               |       | $                   | —     |   | $ | 5,043 |   |
| Mortgage-backed                   |       | 1,885         |       | 1                |       | (10              | )          | 1,876               |       |
| State and municipal               |       | 486           |       | —           |       | —           |       | 486                 |       |
| Corporate                         |       | 279           |       | —           |       | (101             | )          | 178                 |       |
|                              |       |          |       |             |       |             |       |                |       |
| Total                             |       | $             | 7,658      |             | $          | 36               |       | $                   | (111       | ) | $ | 7,583 |   |
|                              |       |          |       |             |       |             |       |                |       |
| **December 31,  2007:**      |       |          |       |             |       |             |       |                |       |
| U.S. Treasury and  agencies       |       | $             | 14,098     |             | $          | 33               |       | $                   | (38        | ) | $ | 14,093 |   |
| Mortgage-backed                   |       | 3,142         |       | 1                |       | (51              | )          | 3,092               |       |
| Corporate                         |       | 441           |       | —           |       | (2               | )          | 439                 |       |
|                              |       |          |       |             |       |             |       |                |       |
| Total                             |       | $             | 17,681     |             | $          | 34               |       | $                   | (91        | ) | $ | 17,624 |   |

 

Forthe quarter ended September 30, 2008, we reviewed all investments with anunrealized loss position for other than temporary impairment (“OTTI”) underSFAS No. 115, “Accounting forCertain Investments in Debt and Equity Securities”**(“SFAS No. 115”) and EITF 99-20, “Recognition of Interest Income andImpairment on Purchased Beneficial Interests and Beneficial Interests ThatContinue to Be Held by a Transferor in Securitized Financial Assets”**(“EITF 99-20”).  Accordingto SFAS No. 115, for individual securities classified as eitheravailable-for-sale (“AFS”) or held-to-maturity (“HTM”), a company shall determine

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**2.**             **SECURITIES- (Continued)**

 

whethera decline in fair value below amortized cost basis is other-than-temporarilyimpaired (“OTTI”).  If the decline in fair value is judged to beOTTI, the cost basis of the individual security shall be written down to fairvalue and the write-down shall be included in earnings.  According to EITF 99-20, for individualsecurities a company should determine whether fair value of the beneficialinterest has declined below its reference amount and whether the decline isother-than-temporary. If, based on a holder’s best estimate of cash flows thata market participant would use in determining the current fair value of thebeneficial interest, there has been an adverse change in estimated cash flowsan other-than-temporary impairment should be considered to have occurred andthe beneficial interest should be written down to fair value with the resultingchange being included in income.

 

Asdiscussed in Note 6 - Fair Value, the fair value of our portfolio of trustpreferred securities has decreased significantly as a result of the currentcredit crisis and lack of liquidity in the financial markets.  Thereare limited trades in trust preferred securities and the majority of holders ofsuch instruments have elected not to participate in the market unless they arerequired to sell as a result of liquidation, bankruptcy, or other forced ordistressed conditions.

 

Todetermine if the four trust preferred securities were other-than-temporarily impairedas of September 30, 2008, we used a discounted cash flow analysis of thefour securities, three continue to carry investment grade ratings and one wasdowngraded to speculative grade during the quarter.  The cash flowmodels used were provided by one of our investment brokers to determine if thecurrent present value of the cash flows expected on each security were stillequivalent to the original cash flows projected on the security whenpurchased.  The cash flows on each security were equivalent to theoriginal cash flows projected when the security was purchased as there havebeen no principal or interest shortfalls.  The cash flow analysistakes into consideration assumptions for prepayments, known and expected defaultsand deferrals for the underlying pool of banks, insurance companies andREITs.  The cash flow analysis supportsour assertion that there is no change in the present value of cash flows, andthat we have determined the decline in fair value below amortized cost istemporary, based on management’s assessment of the full recoverability of thesecurities and that we have the intent and ability to hold these securitiesuntil full recovery or maturity.

 

Inmaking our determination, we also considered all available market informationthat could be obtained without undue cost and effort, and considered the uniquecharacteristics of each trust preferred security individually by assessing theavailable market information and the various risks associated with thatsecurity including:

 

·                  Valuationestimates provided by our investment broker;

·                  Theamount of fair value decline;

·                  Howlong the decline in fair value has existed;

·                  Significantrating agency changes on the issuer;

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

·                  Informationabout the performance of the underlying institutions that issued the debtinstruments, such as net income, return on equity, capital adequacy,non-performing assets, etc;

·                  Ourintent and ability to hold the investment for a period of time sufficient toallow for any anticipated recovery in fair value; and

·                  Otherrelevant observable inputs.

 

Wewill continue to evaluate the portfolio of trust preferred securities for OTTIon a quarterly basis.

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**3.****            ****LOANS**

 

Loans are summarized as follows:

 
| ** **                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**               | ** ** | **2007**              | ** ** |
|                                 |       |                   |       |                  |       |
| Commercial                           |       | $                      | 51,543     |                  | $          | 52,595 |   |
| Real estate  commercial              |       | 542,198                |       | 470,929               |       |
| Real estate  construction            |       | 15,205                 |       | 21,383                |       |
| Residential  mortgage                |       | 166,673                |       | 132,329               |       |
| Consumer and  home equity            |       | 66,424                 |       | 63,090                |       |
| Indirect  consumer                   |       | 29,029                 |       | 27,721                |       |
| Loans held for  sale                 |       | 2,191                  |       | 780                   |       |
|                                 |       | 873,263                |       | 768,827               |       |
| Less:                                | ** ** | ** **             | ** ** | ** **            | ** ** |
| Net deferred  loan origination fees  |       | (778                   | )          | (791                  | )          |
| Allowance for  loan losses           |       | (10,508                | )          | (7,922                | )          |
|                                 |       | (11,286                | )          | (8,713                | )          |
| ** **                           | ** ** | ** **             | ** ** | ** **            | ** ** |
| Loans                                |       | $                      | 861,977    |                  | $          | 760,114 |   |

 

The allowance for loan loss is summarized asfollows:

 
| ** **                           | ** ** | **As of and For the** | ** ** | **As of and For the** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **Three Months Ended**          | ** ** | **Nine Months Ended**           | ** ** |
| ** **                           | ** ** | **September 30,**                    | ** ** | **September 30,**                    | ** ** |
| **(Dollars in thousands)** | ** ** | **2008**                                  | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                 |       |                                      |       |                                      |       |   |   |   |   |
| Balance,  beginning of period        |       | $                                         | 8,917      |                                      | $          | 7,822 |   | $ | 7,922 |   | $ | 7,684 |   |
| Allowance  related to acquisition    |       | —                                    |       | —                                    |       | 327 |   | — |   |
| Provision for  loan losses           |       | 1,720                                     |       | 740                                       |       | 2,819 |   | 948 |   |
| Charge-offs                          |       | (191                                      | )          | (129                                      | )          | (766 | ) | (330 | ) |
| Recoveries                           |       | 62                                        |       | 58                                        |       | 206 |   | 189 |   |
| Balance, end of  period              |       | $                                         | 10,508     |                                      | $          | 8,491 |   | $ | 10,508 |   | $ | 8,491 |   |

 

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

 
| ** **                                   | ** ** | **As of and For the** | ** ** | **As of and For the** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **Nine Months Ended**           | ** ** | **Year Ended**                       | ** ** |
| ** **                                   | ** ** | **September 30,**                    | ** ** | **December 31,**                     | ** ** |
| **(Dollars in thousands)**         | ** ** | **2008**                                  | ** ** | **2007**                                  | ** ** |
|                                         |       |                                      |       |                                      |       |
| End of period  impaired loans                |       | $                                         | 12,302     |                                      | $          | 8,889 |   |
| Amount of  allowance for loan loss allocated |       | 1,925                                     |       | 117                                       |       |
|                                              |            |                                           |            |                                           |            |  |  |

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**3.****            ****LOANS - (Continued)**

 

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

 
| ** **                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**          | ** ** | **2008**               | ** ** | **2007**              | ** ** |
|                                          |       |                   |       |                  |       |
| Restructured                                  |       | $                      | 841        |                  | $          | 2,335 |   |
| Loans past due  over 90 days still on accrual |       | —                 |       | —                |       |
| Non accrual  loans                            |       | 11,461                 |       | 6,554                 |       |
| Total                                         |       | $                      | 12,302     |                  | $          | 8,889 |   |

 

**4.****            ****EARNINGS PER SHARE**

 

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

 
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| **(Dollars in thousands,**            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **except per share data)**       | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                            |       |                             |       |                            |       |   |   |   |   |
| Net income  available to common shareholders    |       | $                                | 991        |                            | $          | 2,131 |   | $ | 4,973 |   | $ | 6,991 |   |
| Basic EPS:                                      |       |                             |       |                            |       |   |   |   |   |
| Weighted average  common shares                 |       | 4,667                            |       | 4,681                           |       | 4,665 |   | 4,739 |   |
| Diluted EPS:                                    |       |                             |       |                            |       |   |   |   |   |
| Weighted average  common shares                 |       | 4,667                            |       | 4,681                           |       | 4,665 |   | 4,739 |   |
| Dilutive effect  of stock options               |       | 17                               |       | 50                              |       | 24 |   | 53 |   |
| Weighted average  common and incremental shares |       | 4,684                            |       | 4,731                           |       | 4,689 |   | 4,792 |   |
| Earnings Per  Share:                            |       |                             |       |                            |       |   |   |   |   |
| Basic                                           |       | $                                | 0.21       |                            | $          | 0.46 |   | $ | 1.07 |   | $ | 1.48 |   |
| Diluted                                         |       | $                                | 0.21       |                            | $          | 0.45 |   | $ | 1.06 |   | $ | 1.46 |   |

 

Stock options for 127,590 and 68,360 shares ofcommon stock were not included in the September 30, 2008 computation ofdiluted earnings per share for the quarter and year to date because theirimpact was anti-dilutive.  Stock optionsfor 28,600 shares of common stock were not included in the September 30,2007 computation of diluted earnings for both the quarter and year to date pershare because they were anti-dilutive.

 

**5.****            ****STOCK OPTION PLAN**

 

Our 2006 Stock Incentive Plan, which is shareholder approved, succeededour 1998 Stock Option and Incentive Plan. Under the 2006 Plan, we may grant either incentive or non-qualifiedstock options to****key employees anddirectors****for a total of 647,350shares of our common stock at not less than fair value at the date such optionsare granted.** **Options available for future grant under the 1998 Plantotaled 38,500 shares and were rolled into the 2006 Plan.** **Webelieve that the ability to award stock options and other forms of stock-basedincentive compensation can assist us in attracting and retaining key employees.Stock-based incentive compensation is also a means to align the interests ofkey employees with those of our shareholders by providing awards intended toreward recipients for our long-term growth.** **The option to purchase shares vestover periods of one to five years and expire ten years after the date of grant.** **Weissue new shares of common stock upon the exercise of stock options. ** **At September 30,2008 options available for future grant under the 2006 Plan totaled 591,750.** **Compensationcost related to options granted under the 1998 and 2006 Plans that was chargedagainst earnings for the nine month periods ended September 30, 2008****and 2007 was $92,000 and $76,000.

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS(CONTINUED)**

 

**5.****            ****STOCK OPTION PLAN - (Continued)**

 

The fair value of each option award is estimated on the date of grantusing the Black-Scholes option valuation model that uses variousweighted-average assumptions.  Therisk-free interest rate is based on the U.S. Treasury yield curve in effect atthe time of grant.  The expectedvolatility is based on the fluctuation in the price of a share of stock overthe period for which the option is being valued and the expected life of theoptions granted represents the period of time the options are expected to beoutstanding.

 

Theweighted-average assumptions for options granted during the period ended September 30,2008 and the resulting estimated weighted average fair value per share ispresented below.

 
| ** **                                     | ** ** | **September 30,** | ** ** |
|------------------------------------------------|------------|------------------------|------------|
| ** **                                     | ** ** | **2008**               | ** ** |
| **Assumptions:**                               |       |                   |       |
| Risk-free  interest rate                       |       | 3.57                   | %          |
| Expected  dividend yield                       |       | 3.29                   | %          |
| Expected life  (years)                         |       | 10                     |       |
| Expected common  stock market price volatility |       | 24                     | %          |
| Estimated fair  value per share                |       | $                      | 5.08       |   |
|                                                |            |                        |            |  |

 

Asummary of option activity under the 1998 and 2006 Plans for the period ended September 30,2008 is presented below:

 
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **           | ** ** |
|--------------------------------------|------------|-------------|------------|--------------|------------|-----------------|------------|----------------------|------------|
| ** **                           | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **           | ** ** |
| ** **                           | ** ** | **Number**  | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate**        | ** ** |
| ** **                           | ** ** | **of**      | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic**        | ** ** |
| ** **                           | ** ** | **Options** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**            | ** ** |
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | **(Dollars In** | ** ** |
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | **Thousands)**       | ** ** |
| Outstanding,  beginning of period    |       | 193,067     |       | $            | 18.95      | ** **      | ** ** | ** **           | ** ** | ** ** |
| Granted during  period               |       | 15,000      |       | 23.14        | ** ** | ** **      | ** ** | ** **           | ** ** |
| Forfeited during  period             |       | (550        | )          | 28.00        | ** ** | ** **      | ** ** | ** **           | ** ** |
| Exercised during  the period         |       | —      |       | —       | ** ** | ** **      | ** ** | ** **           | ** ** |
| Outstanding, end  of period          |       | 207,517     |       | $            | 19.23      |            | 5.1        |                 | $          | — |   |
| ** **                           | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | ** **           | ** ** |
| Eligible for exercise  at period end |       | 128,086     |       | $            | 17.09      |            | 3.5        |                 | $          | 118 |   |

 

The total intrinsic value of options exercised during the period ended September 30,2007 was $65,000.  There were no optionsexercised, modified or settled in cash for the period ended September 30,2008.  There was no tax benefitrecognized from the option exercises as they are considered incentive stockoptions.  Management expects alloutstanding unvested options will vest.

 

Asof September 30, 2008 there was $284,000 of total unrecognizedcompensation cost related to non-vested share-based compensation arrangementsgranted under the 1998 and 2006 Plans. That cost is expected to be recognized over a weighted-average period of3.5 years.  Cash received from optionexercises under all share-based payment arrangements for the periods ended September 30,2008 and 2007 was $0 and $72,000.

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS****(CONTINUED)**

 

**6.****            ****FAIRVALUE**

 

SFASNo. 157 defines fair value as the price that would be received to sell anasset or paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. SFAS No. 157 establishes a fair value hierarchy that prioritizesthe use of inputs used in valuation methodologies into the following three levels:

 

**Level 1:** Quoted prices (unadjusted) for identical assets orliabilities in active markets.  A quotedprice in an active market provides the most reliable evidence of fair value andshall be used to measure fair value whenever available.

 

**Level 2:**Significant other observable inputs other than Level1 prices such as quoted prices for similar assets or liabilities; quoted pricesin markets that are not active; or other inputs that are observable or can becorroborated by observable market data.

 

**Level 3:** Significant unobservable inputs that reflect areporting entity’s own assumptions about the assumptions that marketparticipants would use in pricing an asset or liability.

 

**Assets and Liabilities Measured at Fair Value on a Recurring Basis**

 

Assetsmeasured at fair value on a recurring basis as of September 30, 2008 aresummarized below:

 
| ** **                           | ** ** | ** **             | ** ** | **Quoted Prices in**   | ** ** | ** **                 | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | ** **             | ** ** | **Active Markets for** | ** ** | **Significant Other** | ** ** | **Significant**              | ** ** |
| ** **                           | ** ** | **September 30,** | ** ** | **Identical Assets**        | ** ** | **Observable Inputs** | ** ** | **Unobservable Inputs** | ** ** |
| **(Dollars in thousands)** | ** ** | **2008**               | ** ** | **(Level 1)**               | ** ** | **(Level 2)**         | ** ** | **(Level 3)**           | ** ** |
|                                 |       |                   |       |                             |       |                       |       |                         |       |
| Assets:                              | ** ** | ** **             | ** ** | ** **                       | ** ** | ** **                 | ** ** | ** **                   | ** ** |
| Available-for-sale  securities       |       | $                      | 17,119     |                             | $          | 683                        |       | $                            | 15,202     |   | $ | 1,234 |   |
|                                      |            |                        |            |                                  |            |                            |            |                              |            |  |  |  |  |

 

Thefair values of equity securities are determined by obtaining quoted prices onnationally recognized securities exchanges (Level 1 inputs).  The fair values of debt securities aredetermined by a matrix pricing, which is a mathematical technique widely usedin the industry to value debt securities without relying exclusively on quotedprices 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 limitedactivity or less transparency around inputs to the valuation, securities areclassified within (Level 3) of the valuation hierarchy.  Equity securities that do not have a readilydeterminable fair value are carried at cost and are evaluated for impairment ona periodic basis.

 

BetweenJune 2002 and July 2006, we invested in four AFS and one HTMinvestment grade tranches of trust preferred collateralized debt obligation (“CDO”)securities.  The securities were issued and are referred to asPreferred Term Securities Limited (“PreTSL”).  The underlyingcollateral for the PreTSL is unguaranteed pooled trust preferred securitiesissued by large banks with some small banks, insurance companies and REITsgeographically dispersed across the United States.  We specificallyhold PreTSL IV, VI, XV, XXI and XXII.  All of the PreTSL securities thatwe hold remain investment grade with the exception of PreTSLXXI.  PreTSL XXI had been downgraded to speculative grade during thethird quarter 2008.  Prior to September 30,2008, we determined the fair value of the trust preferred securities using a valuationtechnique based on Level 2 inputs.  The Level 2 inputs includedestimates of the market value for each security provided through our investmentbroker.

 

Sincelate 2007, the markets for collateralized debt obligations and trust preferredsecurities have become increasingly inactive.  The inactivity wasfirst evidenced in late 2007 when new issues of similar securities werediscounted in order to complete the offering.  After December 2007,no new issues of PreTSL have been offered.  Beginning in the secondquarter of 2008, the purchase and sale activity of these securitiessubstantially decreased as investors elected to hold the securities instead ofselling them at substantially depressed prices.  Our brokers haveindicated that little if any activity is occurring in this

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS****(CONTINUED)**

 

**6.****            ****FAIRVALUE****- (Continued)**

 

sectorand that the PreTSL securities trades that are taking place are primarilydistressed sales where the seller must liquidate as a result of insolvency,redemptions or closure of a fund holding the security, or other distressedconditions.  As a result, the bid-ask spreads have widenedsignificantly and the volume of trades decreased significantly compared tohistorical volumes.

 

Asof September 30, 2008, we determined that the market for the trustpreferred securities that we hold and for similar CDO securities (such ashigher-rated tranches within the same CDO security) are also notactive.  That determination was made considering that there are fewobservable transactions for the trust preferred securities or similar CDO securitiesand the observable prices for those transactions have varied substantially overtime.  Consequently, we have considered those observable inputs anddetermined that our trust preferred securities are classified within Level 3 ofthe fair value hierarchy.

 

Wehave determined that an income approach valuation technique (using cash flowsand present value techniques) that maximizes the use of relevant observableinputs and minimizes the use of unobservable inputs is equally or morerepresentative of fair value then relying on the estimation of market valuetechnique used at prior measurement dates, which now has few observable inputsand relies on an inactive market with distressed sales conditions that wouldrequire significant adjustments.

 

Wereceived valuation estimates on our trust preferred securities for September 30,2008.  Those valuation estimates were based on proprietary pricingmodels utilizing significant unobservable inputs in an inactive market withdistressed sales, Level 3 inputs, rather than actual transactions in an activemarket.

 

Inaccordance with the requirements of SFAS 157, we determined that arisk-adjusted discount rate appropriately reflects the reporting entity’sestimate of the assumptions that market participants would use in an active marketto estimate the selling price of the asset at the measurement date.

 

Weconduct a thorough review of fair value hierarchy classifications on aquarterly basis.  Reclassification ofcertain financial instruments may occur when input observability changes.

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS****(CONTINUED)**

 

**6.****            ****FAIRVALUE****- (Continued)**

 

Thetable below presents a reconciliation and income statement classification ofgains and losses for all assets measured at fair value on a recurring basisusing significant unobservable inputs (Level 3) for the period ended September 30,2008:

 
| ** **                               | ** ** | **Fair Value**          | ** ** |
|------------------------------------------|------------|------------------------------|------------|
| ** **                               | ** ** | **Measurements**             | ** ** |
| ** **                               | ** ** | **Using Significant**   | ** ** |
| ** **                               | ** ** | **Unobservable Inputs** | ** ** |
| ** **                               | ** ** | **(Level 3)**           | ** ** |
| **(Dollars in thousands)**     | ** ** | **Asset/Liability**          | ** ** |
|                                     |       |                         |       |
| Beginning  balance, January 1, 2008 |       | $                            | —     |   |
| Total gains or  losses realized:         |       |                         |       |
| Included in  earnings                    |       |                         |       |
| Impairment  charge on security           |       | (118                         | )          |
| Transfers in  and/or out of Level 3      |       | 1,352                        |       |
| Ending balance,  September 30, 2008 |       | $                            | 1,234      |   |

 

**Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis**

 

Assetsmeasured at fair value on a nonrecurring basis as of September 30, 2008 aresummarized below:

 
| ** **                           | ** ** | ** **             | ** ** | **Quoted Prices in**   | ** ** | ** **                 | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | ** **             | ** ** | **Active Markets for** | ** ** | **Significant Other** | ** ** | **Significant**              | ** ** |
| ** **                           | ** ** | **September 30,** | ** ** | **Identical Assets**        | ** ** | **Observable Inputs** | ** ** | **Unobservable Inputs** | ** ** |
| **(Dollars in thousands)** | ** ** | **2008**               | ** ** | **(Level 1)**               | ** ** | **(Level 2)**         | ** ** | **(Level 3)**           | ** ** |
|                                 |       |                   |       |                             |       |                       |       |                         |       |
| Assets:                              | ** ** | ** **             | ** ** | ** **                       | ** ** | ** **                 | ** ** | ** **                   | ** ** |
| Impaired Loans                       |       | $                      | 10,377     |                             | $          | —                     |       | $                            | —     |   | $ | 10,377 |   |
|                                      |            |                        |            |                                  |            |                            |            |                              |            |  |  |  |  |

 

Impaired loans, which are measured forimpairment using the fair value of the collateral for collateral dependentloans, had a carrying amount of $12.3 million, with a valuation allowance of$1.9 million, resulting in an additional provision for loan losses of $1.8million for the 2008 nine month period. Values for collateral dependent loans are generally based on appraisalsobtained from licensed real estate appraisals and in certain circumstancesconsideration of offers obtained to purchase properties prior toforeclosure.  Appraisals for commercialreal estate generally use three methods to derive value: cost, sales or marketcomparison and income approach.  The costmethod bases value on the estimated cost to replace the current property afterconsidering adjustments for depreciation. Values of the market comparison approach evaluate the sales price ofsimilar properties in the same market area. The income approach considers net operating income generated by theproperty and an investors required return. The final value is a reconciliation of these three approaches and takesinto consideration any other factors management deems relevant to arrive at arepresentative fair value.

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS****(CONTINUED)**

 

**7.****            ****BUSINESSCOMBINATION**

 

On June 25, 2008, weacquired 100% of the outstanding shares of FSB Bancshares, Inc. and itswholly owned subsidiary, The Farmers State Bank, located in SouthernIndiana.  The Farmers State Bank hasoffices in Harrison and Floyd County, Indiana. These counties are adjacent to our counties of Meade, Hardin, Bullittand Jefferson.  The branches of The FarmersState Bank are branches of First Financial Service Corporation’s wholly ownedsubsidiary First Federal Savings Bank. Operating results of FSB Bancshares, Inc. have been included in theconsolidated financial statements since the date of the acquisition.  The purpose of the acquisition was toestablish market share in the state of Indiana, expand our customer base,enhance deposit fee income and provide an opportunity to market additionalproducts and services to new customers.

 

Theaggregate purchase price was $14.0 million, paid in cash.  The purchase price resulted in approximately$3.8 million in goodwill and $1.9 million in core deposit intangible.  The core deposit intangible asset is beingamortized over 8.5 years, using an accelerated method.  Goodwill will not be amortized but insteadevaluated periodically for impairment. Goodwill and intangible assets are not deducted for tax purposes.  As of the date of this report, we were in theprocess of obtaining third party valuations and completing fair value estimatesfor certain assets and liabilities. Therefore, the allocation of the purchase price is subject torefinement.

 

The following tablesummarizes the estimated fair value of assets acquired and liabilities assumedat the date of acquisition:

 
| **(Dollars in thousands)**      | ** ** | **Amount** | ** ** |
|-------------------------------------------|------------|------------|------------|
| ** **                                | ** ** | ** ** | ** ** |
| Cash                                      |       | $          | 12,534     |   |
| Securities held  to maturity              |       | 2,512      |       |
| Loans, net                                |       | 48,645     |       |
| FHLB Stock                                |       | 585        |       |
| Premises and  equipment                   |       | 1,019      |       |
| Real estate  acquired through foreclosure |       | 185        |       |
| Goodwill                                  |       | 3,782      |       |
| Core deposit  intangibles                 |       | 1,910      |       |
| Other assets                              |       | 250        |       |
| Total assets  acquired                    |       | 71,422     |       |
|                                      |       |       |       |
| Deposits                                  |       | 55,751     |       |
| Other  liabilities                        |       | 1,671      |       |
| Total  liabilities assumed                |       | 57,422     |       |
|                                      |       |       |       |
| Net assets  acquired                      |       | $          | 14,000     |   |

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS****(CONTINUED)**

 

**7.****            ****BUSINESSCOMBINATION -****(Continued)**

 

**Pro Forma Results of Operations**

 

Thefollowing table presents unaudited pro forma results of operations for thethree and nine months ended September 30, 2008 and 2007, as if the FarmersState Bank acquisition had occurred effective January 1, 2007.  The pro forma financial information is notnecessarily indicative of the results of operations as they actually would havebeen if the acquisition had occurred at January 1, 2007, and is notintended to be a projection of future results.

 
| ** **                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                      | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **(Dollars in thousands, except per share data)** | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Net interest  income                                                            |       | $                                | 8,424      |                            | $          | 8,382 |   | $ | 25,393 |   | $ | 25,005 |   |
| Net income                                                                      |       | 991                              |       | 2,289                           |       | 4,610 |   | 7,461 |   |
| Basic income per  share                                                         |       | $                                | 0.21       |                            | $          | 0.49 |   | $ | 0.99 |   | $ | 1.57 |   |
| Diluted income  per share                                                       |       | 0.21                             |       | 0.48                            |       | 0.98 |   | 1.56 |   |

 

**8.****            ****SUBORDINATEDDEBENTURES**

 

On June 24, 2008, First Federal Statutory Trust III, anunconsolidated 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 forjunior subordinated deferrable interest debentures which we used to finance thepurchase of FSB Bancshares, Inc.  Inaccordance with FASB Interpretation 46, the trust is not consolidated with ourfinancial statements but rather the subordinated debentures are shown as aliability.  The subordinated debentures,which mature on June 24, 2038, can be called at par in whole or in part onor after June 24, 2018. The subordinated debentures pay a fixed rate of 8%for thirty years.  We have the option todefer interest payments on the subordinated debt from time to time for a periodnot to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for theCorporation under current regulatory guidelines.

 

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**Item 2.****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

##### **GENERAL**

##### ** **

Weoperate 21 banking centers in seven contiguous counties in Central Kentuckyalong the Interstate 65 corridor and the Louisville Metropolitan area,including Southern Indiana.  Our marketsrange from the major metropolitan area of Louisville in Jefferson County,Kentucky approximately 40 miles north of our headquarters in Elizabethtown,Kentucky to Hart County, Kentucky, approximately 30 miles south ofElizabethtown to Harrison County, Indiana approximately 60 miles northwest ofour headquarters.  Our markets aresupported by a diversified industry base and have a regional population of over1 million.

 

Weserve the needs and cater to the economic strengths of the local communities inwhich we operate, and we strive to provide a high level of personal andprofessional customer service. We offer a variety of financial services to ourretail and commercial banking customers. These services include personal andcorporate banking services and personal investment financial counselingservices.

 

Through****our personal investment financialcounseling services, we offer a wide variety of mutual funds, equityinvestments, and fixed and variable annuities. We invest in the wholesale capital markets to manage a portfolio ofsecurities and use various forms of wholesale funding. The security portfoliocontains a variety of instruments, including callable debentures, taxable andnon-taxable debentures, fixed and adjustable rate mortgage backed securities,and collateralized mortgage obligations.

 

Ourresults of operations depend primarily on net interest income, which is thedifference between interest income from interest-earning assets and interestexpense on interest-bearing liabilities. Our operations are also affected bynon-interest income, such as service charges, insurance agency revenue, loanfees, gains and losses from the sale of mortgage loans and gains from the saleof real estate held for development. Our principal operating expenses, asidefrom interest expense, consist of compensation and employee benefits, occupancycosts, data processing expense and provisions for loan losses.

 

This discussion and analysis covers material changesin the financial condition since December 31, 2007 and material changes inthe results of operations for the three and nine month periods ending, September 30,2008 as compared to 2007.  It should beread in conjunction with “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” included in the Annual Report on Form 10-Kfor the period ended December 31, 2007.

 

**OVERVIEW**

 

Duringthe second quarter, we completed the acquisition of FSB Bancshares, Inc.and its wholly owned subsidiary, The Farmers State Bank, located in SouthernIndiana.  The Farmers State Bank hadapproximately $65.7 million in total assets and $55.8 million in deposits withoffices in Harrison and Floyd County, Indiana. These counties are adjacent to our Kentucky counties of Meade, Hardin,Bullitt and Jefferson and are part of the Louisville MSA.  The acquisition is anticipated to beaccretive to our earnings during the first full year of the combinedoperations.

 

Duringthe third quarter, we opened our twentieth full —service banking center, whichexpanded our current footprint in Bullitt County, Kentucky.  The Cedar Grove Banking Center complementsour existing branches located in Shepherdsville and Mt. Washington,Kentucky.  We will continue our expansionefforts in the fourth quarter with two additional banking centers underdevelopment.  The first banking center willbe in Hardin County, Kentucky located at the entrance to the Fort Knox militarybase.  The other banking center will beour fourth site in Louisville, Kentucky and located in the Middletown area.

 

Overthe past several years we have focused on enhancing and expanding our retailand commercial banking network in our core markets as well as establishing ourpresence in the Louisville market.  Ourcore markets, where we have a combined 21% market share, have becomeincreasingly competitive as several new banks have entered those markets duringthe past few years.  In order to protectand grow our market share, we are replacing existing branches with newer,enhanced facilities and anticipate constructing several new facilities over thenext few years.  In addition to theenhancement and expansion in our core markets, we have been increasing ourpresence in the Louisville market.  Ouracquisition of FSB Bancshares, Inc. has broadened our retail branchnetwork in the Louisville market, which now extends into Southern Indiana.  Approximately73% of the deposit base in the Louisville market is controlled by sixout-of-state banks.  While the market isvery competitive, we believe this creates an opportunity for smaller communitybanks with more power to make decisions locally.  We 

 

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believeour investment in these initiatives along with our continued commitment to ahigh level of customer service will enhance our market share in our coremarkets and our development in the Louisville market.

 

Ourretail branch network continues to generate encouraging results.  Total deposits have grown 32% over the pastthree years.  Total deposits were $776.9million at September 30, 2008, an increase of $87.7 million from December 31,2007.  The continued development of theretail branch network into the Louisville market also yielded positiveresults.  We have a combined $60.9million in deposits in our three full-service banking centers in the Louisvillemarket.  We opened two of thesefacilities in the second quarter of 2004 to support our growing customer basein this market. In June 2007 we opened our third new full service bankingcenter in Louisville.  Additional siteswithin the Louisville market are under development with our fourth locationscheduled to open in the second quarter of 2009.Competition for deposits continues to bechallenging in all of the markets we serve. This intense competition and future federal rate cuts could add toadditional margin compression as the interest rate environment continues to bevolatile.

 

Wehave developed a strong commercial real estate niche in our markets.  We have an experienced team of bankers whoare focused on providing service and convenience to our customers.  It is quite common for our bankers to closeloans at a customer’s place of business or even the customer’s personalresidence.  This high level of servicehas been especially well received in our Louisville market, which is dominatedby regional banks.  Currently, 26% of ourloan portfolio resides in the Louisville market.  To further develop our commercial bankingrelationships in Louisville, we opened a private banking office in April 2007.  This office is an upscale facilitycomplementing our full service centers in Louisville allowing us to furtherattract commercial deposit relationships in conjunction with our commerciallending relationships.

 

Thisemphasis on commercial lending generated 44% growth in the total loan portfolioand 76% growth in commercial loans over the past three years.  Commercial loans were $608.9 million at September 30,2008, an increase of $64.0 million, or 12% from December 31, 2007.

 

###### **CRITICAL ACCOUNTING POLICIES**

###### ** **

Ouraccounting and reporting policies comply with U.S. generally acceptedaccounting principles and conform to general practices within the bankingindustry.  The accounting policy relatingto the allowance for loan losses is critical to the understanding of ourresults of operations since the application of this policy requires significantmanagement assumptions and estimates that could result in materially differentamounts to be reported if conditions or underlying circumstances were tochange.

 

***Allowance for Loan Losses*****–**We maintain an allowance sufficient to absorbprobable incurred credit losses existing in the loan portfolio. The Allowancefor Loan Loss Review Committee evaluates the allowance for loan losses on aquarterly basis.  We estimate the allowance using past loan lossexperience, known and inherent risks in the portfolio, adverse situations thatmay affect the borrower’s ability to repay, estimated value of the underlyingcollateral, and current economic conditions.  While we estimate theallowance for loan losses based in part on historical losses within each loancategory, estimates for losses within the commercial real estate portfolio aremore dependent upon credit analysis and recent payment performance.Allocations of the allowancemay be made for specific loans or loan categories, but the entire allowance isavailable for any loan that, in management’s judgment, should be charged off.

 

Theallowance consists of specific and general components.  The specific component relates to loans thatare individually classified as impaired or loans otherwise classified assubstandard or doubtful.  The generalcomponent covers non-classified loans and is based on historical lossexperience adjusted for current factors. Allowance estimates are developed withactual loss experience adjusted for current economic conditions.  Allowance estimates are considered a prudentmeasurement of the risk in the loan portfolio and are applied to individualloans based on loan type.

 

Basedon our calculation, an allowance of $10.5 million****or 1.21% of total loans was our estimate of probable losseswithin the loan portfolio as of****September 30,2008.** **This estimate resultedin a provision for loan losses on the income statement of****$2.8 million for the 2008 nine monthperiod.** **If the mix andamount of future charge off percentages differ significantly from thoseassumptions used by management in making its determination, the allowance forloan losses and provision for loan losses on the income statement could bematerially increased.

 

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***Stock-based Compensation*****–**We adopted the provisionsof Statement of Financial Accounting Standards (“SFAS”) No. 123 (R) “Share-BasedPayment (Revised 2004),” on January 1, 2006. Among other things, SFAS No. 123 (R) eliminates the ability to accountfor stock-based compensation using the intrinsic value based method ofaccounting and requires that such transactions be recognized as compensationexpense in the income statement based on their fair values on the date of thegrant.  SFAS No. 123 (R) requires thatmanagement make assumptions including stock price volatility and employeeturnover that are utilized to measure compensation expense.  We estimate fair value of stock optionsgranted at the date of grant using the Black-Scholes option pricing model,which requires the input of highly subjective assumptions, such as volatility,risk free interest rates and dividend pay out rates.

 

***Impairment of Investment Securities*****–**All unrealized losses arereviewed to determine whether the losses are other-than-temporary.  Investment securities are evaluated forother-than-temporary impairment on at least a quarterly basis and morefrequently when economic or market conditions warrant such an evaluation todetermine whether a decline in their value below amortized cost isother-than-temporary.  We evaluate anumber of factors including, but not limited to: valuation estimates provided byinvestment brokers; how much fair value has declined below amortized cost; howlong the decline in fair value has existed; the financial condition of theissuer; significant rating agency changes on the issuer; and management’sintent and ability to hold the security for a period of time sufficient toallow for any anticipated recovery in fair value.

 

The term “other-than-temporary” is not intended toindicate that the decline is permanent, but indicates that the possibility fora near-term recovery of value is not necessarily favorable, or that there is alack of evidence to support a realizable value equal to or greater than thecarrying value of the investment.  Once adecline in value is determined to be other than temporary, the cost basis ofthe security is written down to fair value and a corresponding charge toearnings is recognized.

 

##### **RESULTS OF OPERATIONS**

##### ** **

Net income for the quarter ended September 30,2008 was $991,000 or $0.21 per share diluted compared to $2.1 million or $0.45per share diluted for the same period in 2007. ** **Net income for the nine month period ended September 30, 2008 was$5.0 million or $1.06 per share diluted compared to $7.0 million or $1.46 pershare diluted for the same period a year ago. Earnings decreased for 2008 compared to 2007 due to a decrease inour net interest margin, an increase in provision for loan loss expense, ahigher level of non-interest expense related to our expansion efforts, a writedown taken on investment securities that were other-than-temporarily impairedand a write down on real estate acquired through foreclosure.  ** **Our book value per commonshare increased from $15.50 at September 30, 2007 to $15.95 at September 30,2008.** **Annualizednet income for the first nine months of 2008 generated a return on averageassets of .72% and a return on average equity of 8.80%.** **Thesecompare with a return on average assets of 1.11% and a return on average equityof 12.92% for the first nine months of 2007 also annualized.

 

***Net Interest Income*****–**The principal source of our revenue is netinterest income.  Net interest income isthe difference between interest income on interest-earning assets, such asloans and securities and the interest expense on liabilities used to fund thoseassets, such as interest-bearing deposits and borrowings. Net interest incomeis affected by both changes in the amount and composition of interest-earningassets and interest-bearing liabilities as well as changes in market interestrates.

 

Thegrowth in our commercial loan portfolio has increased net interest income.  The increase in the volume of interestearning assets increased net interest income by $744,000 and $1.3 million forthe three and nine month 2008 periods compared to the same periods a yearago.  Average interest earning assetsincreased $109.1 million for the 2008 quarter and $64.6 million for the ninemonths compared to 2007.  Despite theincrease in interest earning assets, our net interest margin declined.  The yield on earning assets averaged 6.54%and 6.78% for the three and nine month 2008 periods compared to an averageyield on earning assets of 7.67% and 7.66% for the same periods in 2007. This decrease was slightly offset by a decrease in our cost of funds.  On an annualized basis, the net interestmargin as a percent of average earning assets decreased****13 basis points to 3.72% for the quarterended September 30, 2008 and 10 basis points to 3.81% for the nine monthsended September 30, 2008 compared to 3.85% and 3.91% for the same periodsin 2007.

 

Ourcost of funds averaged 3.05% and 3.24% for the quarter and nine month periodsended September 30, 2008 compared to an average cost of funds of 4.20% and4.11% for the same periods in 2007. Going forward, our cost of funds isexpected to continue to decrease as certificates of deposit re-price and rolloff into new certificates of deposit at lower interest rates.

 

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Ournet interest margin is likely to compress in future quarters as a result of theFederal Open Market Committee (FOMC) decreasing the Federal Funds rate by 225basis points in 2008 through September 30th.  In addition, the FOMC decreased the federalfunds rate by an additional 50 basis points on October 8, 2008 in anemergency rate cut.  Variable rate loansthat are tied to the federal prime rate are immediately re-priced downward withthese rate cuts.  However, interest ratespaid on customer deposits have not adjusted downward proportionately with thedeclining interest yields on loans and investments.  This will in turn lower our net interestmargin.

 

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**AVERAGE BALANCE SHEET**

 

The following tableprovides information relating to our average balance sheet and reflects theaverage yield on assets and average cost of liabilities for the indicatedperiods.  Yields and costs for theperiods presented are derived by dividing income or expense by the averagemonthly balance of assets or liabilities, respectively.

 
| ** **                                           | ** ** | **Quarter Ended September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                       | ** ** | **2007** | ** ** |
| ** **                                           | ** ** | **Average**                                    | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)**                 | ** ** | **Balance**                                    | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** |
|                                                 |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                           |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning  assets:                            |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury  and agencies                          |       | $                                              | 5,332      |   | $ | 49 |   | 3.66 | % | $ | 16,583 |   | $ | 146 |   | 3.49 | % |
| Mortgage-backed  securities                          |       | 8,501                                          |       | 91 |   | 4.26 |   | 11,514 |   | 125 |   | 4.31 |   |
| Equity  securities                                   |       | 1,775                                          |       | 12 |   | 2.69 |   | 2,036 |   | 19 |   | 3.70 |   |
| State and  political subdivision securities**(1)**   |       | 9,416                                          |       | 136 |   | 5.75 |   | 9,405 |   | 155 |   | 6.54 |   |
| Corporate bonds                                      |       | 3,110                                          |       | 47 |   | 6.01 |   | 3,820 |   | 65 |   | 6.75 |   |
| Loans**(2) (3) (4)**                       |       | 861,230                                        |       | 14,337 |   | 6.62 |   | 745,028 |   | 14,760 |   | 7.86 |   |
| FHLB stock                                           |       | 8,410                                          |       | 113 |   | 5.35 |   | 7,621 |   | 126 |   | 6.56 |   |
| Interest bearing  deposits                           |       | 7,685                                          |       | 90 |   | 4.66 |   | 375 |   | 9 |   | 9.53 |   |
| **Total  interest earning assets**                   |       | 905,459                                        |       | 14,875 |   | 6.54 |   | 796,382 |   | 15,405 |   | 7.67 |   |
| Less: Allowance  for loan losses                     |       | (9,029                                         | )          |   |   |   |   | (8,024 | ) |   |   |   |   |
| Non-interest  earning assets                         |       | 84,270                                         |       |   |   |   |   | 63,557 |   |   |   |   |   |
| **Total  assets**                                    |       | $                                              | 980,700    |   |   |   |   |   | $ | 851,915 |   |   |   |   |   |
|                                                 |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**       |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing  liabilities:                       |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                     |       | $                                              | 114,518    |   | $ | 442 |   | 1.54 | % | $ | 92,877 |   | $ | 731 |   | 3.12 | % |
| NOW and money  market accounts                       |       | 142,036                                        |       | 322 |   | 0.90 |   | 126,193 |   | 631 |   | 1.98 |   |
| Certificates of  deposit and other time deposits     |       | 478,747                                        |       | 4,561 |   | 3.79 |   | 432,569 |   | 5,333 |   | 4.89 |   |
| Short term  borrowings                               |       | 29,392                                         |       | 156 |   | 2.11 |   | 33,639 |   | 465 |   | 5.48 |   |
| FHLB advances                                        |       | 52,993                                         |       | 610 |   | 4.58 |   | 29,929 |   | 345 |   | 4.57 |   |
| Subordinated  debentures                             |       | 18,000                                         |       | 315 |   | 6.96 |   | 10,000 |   | 167 |   | 6.63 |   |
| **Total  interest bearing liabilities**              |       | 835,686                                        |       | 6,406 |   | 3.05 |   | 725,207 |   | 7,672 |   | 4.20 |   |
| Non-interest  bearing liabilities:                   |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest  bearing deposits                       |       | 62,606                                         |       |   |   |   |   | 48,728 |   |   |   |   |   |
| Other  liabilities                                   |       | 6,261                                          |       |   |   |   |   | 5,724 |   |   |   |   |   |
| **Total  liabilities**                               |       | 904,553                                        |       |   |   |   |   | 779,659 |   |   |   |   |   |
|                                                 |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’  equity                           |       | 76,147                                         |       |   |   |   |   | 72,256 |   |   |   |   |   |
| **Total  liabilities and stockholders’ equity** |       | $                                              | 980,700    |   |   |   |   |   | $ | 851,915 |   |   |   |   |   |
|                                                 |       |                                           |       |   |   |   |   |   |   |   |   |   |   |
| **Net  interest income**                             |       |                                           |       | $ | 8,469 |   |   |   |   |   | $ | 7,733 |   |   |   |
| **Net  interest spread**                             |       |                                           |       |   |   | 3.49 | % |   |   |   |   | 3.47 | % |
| **Net  interest margin**                             |       |                                           |       |   |   | 3.72 | % |   |   |   |   | 3.85 | % |

 

----

**(1) **Taxableequivalent yields are calculated assuming a 34% federal income tax rate.

**(2) **Includesloan fees, immaterial in amount, in both interest income and the calculation ofyield on loans.

**(3) **Calculationsinclude non-accruing loans in the average loan amounts outstanding.

**(4) **Includesloans held for sale.

**(5) **Annualized

 

25

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| ** **                                           | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                           | ** ** | **2008**                                 | ** ** | **2007** | ** ** |
| ** **                                           | ** ** | **Average**                              | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)**                 | ** ** | **Balance**                              | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** |
|                                                 |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                           |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning  assets:                            |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury  and agencies                          |       | $                                        | 7,126      |   | $ | 216 |   | 4.05 | % | $ | 19,252 |   | $ | 519 |   | 3.60 | % |
| Mortgage-backed  securities                          |       | 9,311                                    |       | 297 |   | 4.26 |   | 12,335 |   | 398 |   | 4.31 |   |
| Equity  securities                                   |       | 1,683                                    |       | 42 |   | 3.33 |   | 2,081 |   | 56 |   | 3.60 |   |
| State and  political subdivision securities**(1)**   |       | 9,478                                    |       | 450 |   | 6.34 |   | 10,035 |   | 480 |   | 6.40 |   |
| Corporate bonds                                      |       | 3,092                                    |       | 123 |   | 5.31 |   | 4,721 |   | 250 |   | 7.08 |   |
| Loans**(2) (3) (4)**                       |       | 811,036                                  |       | 41,718 |   | 6.87 |   | 731,276 |   | 43,065 |   | 7.87 |   |
| FHLB stock                                           |       | 7,983                                    |       | 317 |   | 5.30 |   | 7,621 |   | 368 |   | 6.46 |   |
| Interest bearing  deposits                           |       | 3,257                                    |       | 100 |   | 4.10 |   | 1,043 |   | 47 |   | 6.03 |   |
| **Total  interest earning assets**                   |       | 852,966                                  |       | 43,263 |   | 6.78 |   | 788,364 |   | 45,183 |   | 7.66 |   |
| Less: Allowance  for loan losses                     |       | (8,537                                   | )          |   |   |   |   | (7,828 | ) |   |   |   |   |
| Non-interest  earning assets                         |       | 75,195                                   |       |   |   |   |   | 61,453 |   |   |   |   |   |
| **Total  assets**                                    |       | $                                        | 919,624    |   |   |   |   |   | $ | 841,989 |   |   |   |   |   |
|                                                 |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**       |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing  liabilities:                       |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                     |       | $                                        | 105,827    |   | $ | 1,389 |   | 1.75 | % | $ | 98,894 |   | $ | 2,417 |   | 3.27 | % |
| NOW and money  market accounts                       |       | 135,172                                  |       | 1,078 |   | 1.07 |   | 121,932 |   | 1,599 |   | 1.75 |   |
| Certificates of  deposit and other time deposits     |       | 437,792                                  |       | 13,348 |   | 4.07 |   | 422,608 |   | 15,066 |   | 4.77 |   |
| Short term  borrowings                               |       | 34,132                                   |       | 661 |   | 2.59 |   | 35,303 |   | 1,452 |   | 5.50 |   |
| FHLB advances                                        |       | 53,026                                   |       | 1,808 |   | 4.55 |   | 29,866 |   | 1,022 |   | 4.58 |   |
| Subordinated  debentures                             |       | 13,556                                   |       | 649 |   | 6.40 |   | 10,000 |   | 549 |   | 7.34 |   |
| **Total  interest bearing liabilities**              |       | 779,505                                  |       | 18,933 |   | 3.24 |   | 718,603 |   | 22,105 |   | 4.11 |   |
| Non-interest  bearing liabilities:                   |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest  bearing deposits                       |       | 58,847                                   |       |   |   |   |   | 45,603 |   |   |   |   |   |
| Other  liabilities                                   |       | 5,762                                    |       |   |   |   |   | 5,452 |   |   |   |   |   |
| **Total  liabilities**                               |       | 844,114                                  |       |   |   |   |   | 769,658 |   |   |   |   |   |
|                                                 |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’  equity                           |       | 75,510                                   |       |   |   |   |   | 72,331 |   |   |   |   |   |
| **Total  liabilities and stockholders’ equity** |       | $                                        | 919,624    |   |   |   |   |   | $ | 841,989 |   |   |   |   |   |
|                                                 |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| **Net  interest income**                             |       |                                     |       | $ | 24,330 |   |   |   |   |   | $ | 23,078 |   |   |   |
| **Net  interest spread**                             |       |                                     |       |   |   | 3.53 | % |   |   |   |   | 3.55 | % |
| **Net  interest margin**                             |       |                                     |       |   |   | 3.81 | % |   |   |   |   | 3.91 | % |

 

----

**(1) **Taxableequivalent yields are calculated assuming a 34% federal income tax rate.

**(2) **Includesloan fees, immaterial in amount, in both interest income and the calculation ofyield on loans.

**(3) **Calculationsinclude non-accruing loans in the average loan amounts outstanding.

**(4) **Includesloans held for sale.

**(5) **Annualized

 

26

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**RATE/VOLUME ANALYSIS**

 

Thetable below provides information regarding changes in interest income andinterest expense for the indicated periods. For each category of interest-earning assets and interest-bearingliabilities, information is provided on changes attributable to (1) changesin 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 proportionatelyallocated between rate and volume variance.

 
| ** **                                       | ** ** | **Three Months Ended**    | ** ** | **Nine Months Ended**     | ** ** |
|--------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **September 30,**              | ** ** | **September 30,**              | ** ** |
| ** **                                       | ** ** | **2008 vs. 2007**         | ** ** | **2008 vs. 2007**         | ** ** |
| ** **                                       | ** ** | **Increase (decrease)**        | ** ** | **Increase (decrease)**        | ** ** |
| ** **                                       | ** ** | **Due to change in** | ** ** | **Due to change in** | ** ** |
| ** **                                       | ** ** | ** **                          | ** ** | ** **                          | ** ** | **Net** | ** ** | ** ** | ** ** | ** ** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)**             | ** ** | **Rate**                            | ** ** | **Volume**                          | ** ** | **Change** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Change** | ** ** |
| ** **                                       |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Interest  income:**                            |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| U.S. Treasury  and agencies                      |       | $                                   | 6          |                                | $          | (103 | ) | $ | (97 | ) | $ | 58 |   | $ | (361 | ) | $ | (303 | ) |
| Mortgage-backed  securities                      |       | (2                                  | )          | (32                                 | )          | (34 | ) | (4 | ) | (97 | ) | (101 | ) |
| Equity  securities                               |       | (5                                  | )          | (2                                  | )          | (7 | ) | (4 | ) | (10 | ) | (14 | ) |
| State and  political subdivision securities      |       | (19                                 | )          | —                              |       | (19 | ) | (4 | ) | (26 | ) | (30 | ) |
| Corporate bonds                                  |       | (18                                 | )          | —                              |       | (18 | ) | (127 | ) | — |   | (127 | ) |
| Loans                                            |       | (2,544                              | )          | 2,121                               |       | (423 | ) | (5,769 | ) | 4,422 |   | (1,347 | ) |
| FHLB stock                                       |       | (25                                 | )          | 12                                  |       | (13 | ) | (67 | ) | 16 |   | (51 | ) |
| Interest bearing  deposits                       |       | (7                                  | )          | 88                                  |       | 81 |   | (19 | ) | 72 |   | 53 |   |
|                                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Total  interest earning assets**               |       | (2,614                              | )          | 2,084                               |       | (530 | ) | (5,936 | ) | 4,016 |   | (1,920 | ) |
|                                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Interest  expense:**                           |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| Savings accounts                                 |       | (432                                | )          | 143                                 |       | (289 | ) | (1,187 | ) | 159 |   | (1,028 | ) |
| NOW and money  market accounts                   |       | (380                                | )          | 71                                  |       | (309 | ) | (680 | ) | 159 |   | (521 | ) |
| Certificates of  deposit and other time deposits |       | (1,300                              | )          | 528                                 |       | (772 | ) | (2,244 | ) | 526 |   | (1,718 | ) |
| Short term  borrowings                           |       | (309                                | )          | —                              |       | (309 | ) | (791 | ) | — |   | (791 | ) |
| FHLB advances                                    |       | —                              |       | 265                                 |       | 265 |   | (4 | ) | 790 |   | 786 |   |
| Subordinated  debentures                         |       | 8                                   |       | 140                                 |       | 148 |   | (77 | ) | 177 |   | 100 |   |
|                                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Total  interest bearing liabilities**          |       | (2,413                              | )          | 1,147                               |       | (1,266 | ) | (4,983 | ) | 1,811 |   | (3,172 | ) |
|                                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Net  change in net interest income**           |       | $                                   | (201       | )                                   | $          | 937 |   | $ | 736 |   | $ | (953 | ) | $ | 2,205 |   | $ | 1,252 |   |

 

***Non-Interest Income and Non-InterestExpense***

 

Thefollowing tables provide a comparison of the components of non-interest incomeand expenses for the periods ended September 30, 2008 and 2007.  The tables show the dollar and percentagechange from 2007 to 2008.  Below eachtable is a discussion of significant changes and trends.

 
| ** **                                              | ** ** | **Three Months Ended** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **September 30,**           | ** ** |
| **(Dollars in thousands)**                              | ** ** | **2008**                         | ** ** | **2007** | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest  income**                                | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer service  fees on deposit accounts              |       | $                                | 1,817      |   | $ | 1,511 |   | $ | 306 |   | 20.3 | % |
| Gain on sale of  mortgage loans                         |       | 179                              |       | 144 |   | 35 |   | 24.3 | % |
| Gain on sale of  investments                            |       | 52                               |       | — |   | 52 |   | 100.0 | % |
| Write down on  real estate acquired through foreclosure |       | (151                             | )          | — |   | (151 | ) | 100.0 | % |
| Brokerage  commissions                                  |       | 109                              |       | 106 |   | 3 |   | 2.8 | % |
| Other income                                            |       | 361                              |       | 444 |   | (83 | ) | -18.7 | % |
|                                                    |       | $                                | 2,367      |   | $ | 2,205 |   | $ | 162 |   | 7.3 | % |

 

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| ** **                                              | ** ** | **Nine Months Ended**  | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|
| ** **                                              | ** ** | **September 30,** | ** ** |
| **(Dollars in thousands)**                              | ** ** | **2008**               | ** ** | **2007** | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest  income**                                | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer service  fees on deposit accounts              |       | $                      | 4,865      |   | $ | 4,274 |   | $ | 591 |   | 13.8 | % |
| Gain on sale of  mortgage loans                         |       | 566                    |       | 435 |   | 131 |   | 30.1 | % |
| Gain on sale of  investments                            |       | 52                     |       | — |   | 52 |   | 100.0 | % |
| Gain on sale of  real estate held for development       |       | —                 |       | 227 |   | (227 | ) | -100.0 | % |
| Losses on  securities transactions                      |       | (216                   | )          | — |   | (216 | ) | 100.0 | % |
| Write down on  real estate acquired through foreclosure |       | (160                   | )          | — |   | (160 | ) | 100.0 | % |
| Brokerage  commissions                                  |       | 352                    |       | 308 |   | 44 |   | 14.3 | % |
| Other income                                            |       | 1,001                  |       | 945 |   | 56 |   | 5.9 | % |
|                                                    |       | $                      | 6,460      |   | $ | 6,189 |   | $ | 271 |   | 4.4 | % |

 

Growthin customer service fees on deposit accounts, our largest component ofnon-interest income, is primarily due to growth in customer deposits, overdraftfee income on retail checking accounts and the sale of fee-based products for2008.  We continue to increase ourcustomer base through cross-selling opportunities and marketing initiatives andpromotions.  In addition, we continue toemphasize growing our checking account base to better enhance our profitabilityand franchise value.

 

We originate qualified VA, KHC, RHC and conventionalsecondary market loans and sell them into the secondary market with servicingrights released.  For the quarter and thefirst nine months of 2008, gain on sale of mortgage loans increased due to anincrease in the volume of loans closed.

 

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 2008 we recorded a gain on sale of investments of $52,000.  Gains on investment securities are infrequent in nature and are not a consistent recurring source of income.

 

Through our subsidiary, First Federal Office Park, we hold commercial lots adjacent to our home office on RingRoad in Elizabethtown, that are available for sale. During the March 2007 quarter we recorded $227,000 in gains from a lot sale.  Currently, one of the original nine lots held for sale remains unsold.

 

We recognized another-than-temporary impairment charge of $216,000 at June 30, 2008 oncertain equity securities with a cost basis of $840,000. Management believes thisimpairment was primarily attributable to current economic conditions. Sincerecovery does not appear likely in the near future, we recognized theimpairment losses. Previously, we recognized the decline in market value ofthese equity securities in stockholders’ equity through accumulated othercomprehensive income.

 

Further reducingnon-interest income for the 2008 period was a 10% or $151,000 write-down, inthe third quarter, of the carrying value of a real estate owned property thathad been held for twelve months.

 
| ** **                               | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------|------------|------------------------|------------|
| ** **                               | ** ** | **September 30,** | ** ** |
| **(Dollars in thousands)**               | ** ** | **2008**               | ** ** | **2007** | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest  expenses**               | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Employee  compensation and benefits      |       | $                      | 3,867      |   | $ | 3,136 |   | $ | 731 |   | 23.3 | % |
| Office occupancy  expense and equipment  |       | 779                    |       | 604 |   | 175 |   | 29.0 | % |
| Marketing and  advertising               |       | 215                    |       | 228 |   | (13 | ) | -5.7 | % |
| Outside services  and data processing    |       | 882                    |       | 638 |   | 244 |   | 38.2 | % |
| Bank franchise  tax                      |       | 258                    |       | 234 |   | 24 |   | 10.3 | % |
| Amortization of  core deposit intangible |       | 56                     |       | — |   | 56 |   | 100.0 | % |
| Other expense                            |       | 1,580                  |       | 1,166 |   | 414 |   | 35.5 | % |
|                                     |       | $                      | 7,637      |   | $ | 6,006 |   | $ | 1,631 |   | 27.2 | % |

 

28

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| ** **                                                | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|
| ** **                                                | ** ** | **September 30,** | ** ** |
| **(Dollars in thousands)**                                | ** ** | **2008**               | ** ** | **2007** | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest  expenses**                                | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Employee  compensation and benefits                       |       | $                      | 10,765     |   | $ | 9,365 |   | $ | 1,400 |   | 14.9 | % |
| Office occupancy  expense and equipment                   |       | 2,112                  |       | 1,766 |   | 346 |   | 19.6 | % |
| Marketing and advertising                                 |       | 638                    |       | 677 |   | (39 | ) | -5.8 | % |
| Outside services  and data processing                     |       | 2,365                  |       | 1,974 |   | 391 |   | 19.8 | % |
| Bank franchise  tax                                       |       | 761                    |       | 699 |   | 62 |   | 8.9 | % |
| Write off of  issuance cost of Trust Preferred Securities |       | —                 |       | 229 |   | (229 | ) | -100.0 | % |
| Amortization of  core deposit intangible                  |       | 59                     |       | — |   | 59 |   | 100.0 | % |
| Other expense                                             |       | 3,791                  |       | 3,112 |   | 679 |   | 21.8 | % |
|                                                      |       | $                      | 20,491     |   | $ | 17,822 |   | $ | 2,669 |   | 15.0 | % |

 

Employeecompensation and benefits is the largest component of non-interestexpense.  Since 2006, three commerciallending associates and twenty-two retail associates have been added with ourexpansion efforts. These associates were hired for a commercial private bankingcenter which opened in April 2007, a new Louisville retail branch facilitythat opened in June 2007, a new Bullitt County retail branch facility thatopened in August 2008 and other positions to support our growth.  Twenty additional associates were added inthe second quarter of 2008 as a result of the recent acquisition.  We look for a continued increase in employeecompensation and benefits expense in line with recent years, as we progresswith our retail expansion and market protection efforts.

 

Officeoccupancy expense and equipment and outside services and data processingincreased due to additional operating expenses related to our expansion effortsand a system upgrade.  We anticipate theincreased level of non-interest expense to continue in 2008 with additionalretail expansion.

 

Included in non-interest expense for the September 2007 period is$229,000 in unamortized subordinated debentures issuance cost from theredemption of all of our underlying $10.0 million issuance of cumulative trustpreferred securities.  These securitiespaid distributions at a quarterly adjustable rate of LIBOR plus 360 basis points(8.97% on March 26, 2007).  Weissued new subordinated debentures at a 10 year fixed rate of 6.69%.

 

Otherexpense increased due to increases in interchange expense, REO expense andlosses on NOW accounts.  Interchangeexpense increased due to the switch to real-time debit card processing, whichis more expensive per item than the batch processing method we usedpreviously.  REO expense relating torepair, maintenance and taxes increased due to increases in real estateacquired through foreclosure.

 

Ourefficiency ratio was 67% for the nine months ended September 30, 2008compared to 61% for the 2007 period.

 

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**ANALYSIS OF FINANCIAL CONDITION**

 

Total assets at September 30, 2008 increased to $991.3million compared to $872.7 million at December 31, 2007, an increase of$118.6 million.  Approximately $71.4million of the increase was attributable to the June 2008 acquisition ofFSB Bancshares, Inc.

 

##### **Loans**

##### ** **

Net loans increased $101.9 million to $862.0 million at September 30,2008 compared to $760.1 million at December 31, 2007.  The recent acquisition of FSB Bancshares, Inc.contributed approximately $48.6 million in new loans.  Our commercial real estate portfolioincreased $71.3 million to $542.2 million at September 30, 2008.  For the 2008 period, these loans comprised62% of the total loan portfolio compared to 60% at September 30,2007.  Our residential mortgage loanportfolio increased for the 2008 period due to the recent acquisition by $34.3million.  The residential mortgage loanswe acquired are seasoned performing loans and none are considered to have anysub-prime characteristics. Consumer, home equity, and indirect consumer loansalso increased during the 2008 period. Commercial loans remained relatively constant during the 2008period.  Offsetting this growth was a$6.2 million decrease in the real estate construction loan portfolio to $15.2million at September 30, 2008, compared to $21.4 million****at December 31, 2007.  For 2008, thegrowth in commercial real estate loans is expected to continue in line withrecent periods as we continue to emphasize this type of lending.

 
| ** **                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**               | ** ** | **2007**              | ** ** |
|                                 |       |                   |       |                  |       |
| Commercial                           |       | $                      | 51,543     |                  | $          | 52,595 |   |
| Real estate  commercial              |       | 542,198                |       | 470,929               |       |
| Real estate  construction            |       | 15,205                 |       | 21,383                |       |
| Residential  mortgage                |       | 166,673                |       | 132,329               |       |
| Consumer and  home equity            |       | 66,424                 |       | 63,090                |       |
| Indirect  consumer                   |       | 29,029                 |       | 27,721                |       |
| Loans held for  sale                 |       | 2,191                  |       | 780                   |       |
|                                 |       | 873,263                |       | 768,827               |       |
| Less:                                | ** ** | ** **             | ** ** | ** **            | ** ** |
| Net deferred  loan origination fees  |       | (778                   | )          | (791                  | )          |
| Allowance for  loan losses           |       | (10,508                | )          | (7,922                | )          |
|                                 |       | (11,286                | )          | (8,713                | )          |
| ** **                           | ** ** | ** **             | ** ** | ** **            | ** ** |
| Loans                                |       | $                      | 861,977    |                  | $          | 760,114 |   |

 

**Allowance and Provision for Loan Losses**

 

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

 

The Allowance for Loan Loss Review Committeeevaluates the allowance for loan losses quarterly to maintain a levelsufficient to absorb probable incurred credit losses existing in the loanportfolio.  Periodic provisions to theallowance are made as needed.  TheCommittee determines the allowance by applying loss estimates to graded loansby categories, as described below.  Inaddition, the Committee analyzes such factors as changes in lending policiesand procedures; underwriting standards; collection; charge-off and recoveryhistory; changes in national and local economic business conditions anddevelopments; changes in the characteristics of the portfolio; ability anddepth of lending management and staff; changes in the trend of the volume andseverity of past due, non-accrual and classified loans; troubled debtrestructuring and other loan modifications; and results of regulatoryexaminations.

 

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The following table analyzes loan loss experiencefor the periods indicated.

 
| ** **                                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **(Dollars in thousands)**                                      | ** ** | **2008**                         | ** ** | **2007**                        | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                      |       |                             |       |                            |       |   |   |   |   |
| **Balance  at beginning of period**                                       |       | $                                | 8,917      |                            | $          | 7,822 |   | $ | 7,922 |   | $ | 7,684 |   |
| Allowance  related to acquisition                                         |       | —                           |       | —                          |       | 327 |   | — |   |
| Loans  charged-off:                                                       |       |                             |       |                            |       |   |   |   |   |
| Real estate  mortgage                                                     |       | —                           |       | 18                              |       | 15 |   | 18 |   |
| Consumer                                                                  |       | 137                              |       | 111                             |       | 402 |   | 295 |   |
| Commercial                                                                |       | 54                               |       | —                          |       | 349 |   | 17 |   |
| Total  charge-offs                                                        |       | 191                              |       | 129                             |       | 766 |   | 330 |   |
| Recoveries:                                                               |       |                             |       |                            |       |   |   |   |   |
| Real estate  mortgage                                                     |       | 2                                |       | —                          |       | 3 |   | 9 |   |
| Consumer                                                                  |       | 60                               |       | 55                              |       | 185 |   | 174 |   |
| Commercial                                                                |       | —                           |       | 3                               |       | 18 |   | 6 |   |
| Total recoveries                                                          |       | 62                               |       | 58                              |       | 206 |   | 189 |   |
|                                                                      |       |                             |       |                            |       |   |   |   |   |
| **Net  loans charged-off**                                                |       | 129                              |       | 71                              |       | 560 |   | 141 |   |
|                                                                      |       |                             |       |                            |       |   |   |   |   |
| Provision for  loan losses                                                |       | 1,720                            |       | 740                             |       | 2,819 |   | 948 |   |
|                                                                      |       |                             |       |                            |       |   |   |   |   |
| **Balance  at end of period**                                             |       | $                                | 10,508     |                            | $          | 8,491 |   | $ | 10,508 |   | $ | 8,491 |   |
|                                                                      |       |                             |       |                            |       |   |   |   |   |
| Allowance for  loan losses to total loans (excluding loans held for sale) |       |                             |       |                            |       | 1.21 | % | 1.11 | % |
| Annualized net  charge-offs to average loans  outstanding                 | ** ** | ** **                       | ** ** | ** **                      | ** ** | 0.09 | % | 0.02 | % |
| Allowance for  loan losses to total  non-performing loans                 | ** ** | ** **                       | ** ** | ** **                      | ** ** | 85 | % | 111 | % |

 

Theprovision for loan losses increased $980,000 to $1.7 million for the quarterended September 30, 2008, and increased $1.9 million to $2.8 million forthe nine months ended September 30, 2008 compared to the same periods in2007.  The increase for the quarter wasrelated to an additional $1.4 million of specific reserve for a classifiedcommercial real estate development loan. This relationship had been previouslyclassified during the first quarter of 2008. The increase in provision for loan losses for the nine month period wasrelated to growth in the loan portfolio as well as from specific reserves forloans classified during 2008.  Theprovision for the 2007 period was smaller due to the improved performance ofone of our credit relationships which reduced the allowance allocated to theloan.  The allowance for loan lossesincreased $2.0 million to $10.5 million from September 30, 2007 to September 30,2008. ** **Theincrease was related to $329,000 in allowance added as a result of the FSBBancshares, Inc. acquisition, an increase in net loans for 2008, as wellas provision recorded, in conjunction with a $17.8 million increase inclassified loans for the 2008 period.

 

Federalregulations require banks to classify their own assets on a regular basis.  The regulations provide for three categoriesof classified loans — substandard, doubtful and loss.  A bank must establish general allowances forloan losses for any assets classified as substandard or doubtful. If an assetor portion thereof is classified as loss, the bank must either establishspecified allowances for loan losses in the amount of 100% of the portion ofthe asset classified loss, or charge off the amount of the loss.

 

Thefollowing table provides information with respect to classified loans for theperiods indicated:

** **
| ** **                           | ** ** | **September 30,** | ** ** |
|--------------------------------------|------------|------------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**               | ** ** | **2007** | ** ** |
| **Classified  Loans**                | ** ** | ** **             | ** ** | ** ** | ** ** |
| Substandard                          |       | $                      | 32,070     |   | $ | 14,220 |   |
| Doubtful                             |       | —                 |       | 65 |   |
| Loss                                 |       | 55                     |       | 68 |   |
| Total Classified                     |       | $                      | 32,125     |   | $ | 14,353 |   |

 

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The$17.9 million increase in substandard assets for 2008 was primarily the result****of downgrading loans with nine borrowersin the amounts of $8.5 million, $4.1 million, $1.7 million, $1.6 million, $1.5million, $1.5 million, $1.0 million, $975,000 and $870,000,****respectively.** **Offsetting thisincrease was the upgrade of a classified loan having a balance of $823,000 andthe transfer of three classified loans having balances of $1.5 million, $1.3million and $1.1 million to real estate acquired through foreclosure.Approximately $20.3 million of the total classified loans were related to realestate development or real estate construction loans in our market area.  Classified consumer loans totaled $ 1.3million, classified mortgage loans totaled $4.7 million and classifiedcommercial loans totaled $5.8 million. We remain well secured and adequately collateralized with these credits.For more information on collection efforts, evaluation of collateral and howloss amounts are estimated, see “Non-Performing Assets.”

 

Althoughwe may allocate a portion of the allowance to specific loans or loancategories, the entire allowance is available for active charge-offs.  We develop our allowance estimates based onactual loss experience adjusted for current economic conditions.  Allowance estimates represent a prudentmeasurement of the risk in the loan portfolio, which we apply to individualloans based on loan type.

 

##### **Non-PerformingAssets**

##### ** **

Non-performing assets consist of certain restructured loansfor which interest rate or other terms have been renegotiated, loans on whichinterest is no longer accrued, real estate acquired through foreclosure andrepossessed assets.  We do not have anyloans longer than 90 days past due still on accrual.  Loans, including impaired loans under SFAS114, are placed on non-accrual status when they become past due 90 days or moreas to principal or interest, unless they are adequately secured and in theprocess of collection.  Loans areconsidered impaired when we no longer anticipate full principal or interestpayments in accordance with the contractual loan terms.  We carry impaired loans at the present valueof expected future cash flows discounted at the loan’s effective interest rateor at the fair value of the collateral if the loan is secured by collateral.

 

Wereview our loans on a regular basis and implement normal collection procedureswhen a borrower fails to make a required payment on a loan.  If the delinquency on a mortgage loan exceeds90 days and is not cured through normal collection procedures or an acceptablearrangement is not worked out with the borrower, we institute measures toremedy the default, including commencing a foreclosure action.  We generally charge off consumer loans whenmanagement deems a loan uncollectible and any available collateral has beenliquidated.  We handle commercialbusiness and real estate loan delinquencies on an individual basis with theadvice of legal counsel.

 

Werecognize interest income on loans on the accrual basis except for those loansin a non-accrual of income status. We discontinue accruing interest on impairedloans when management believes, after consideration of economic and businessconditions and collection efforts that the borrowers’ financial condition is suchthat collection of interest is doubtful, typically after the loan becomes 90days delinquent.  When we discontinueinterest accrual, we reverse existing accrued interest and subsequentlyrecognize interest income only to the extent we receive cash payments.

 

We classify real estate acquired as a result offoreclosure or by deed in lieu of foreclosure as real estate owned until suchtime as it is sold. We classify new and used automobile, motorcycle and allterrain vehicles acquired as a result of foreclosure as repossessed assetsuntil they are sold. When such property is acquired we record it at the lowerof the unpaid principal balance of the related loan or its fair marketvalue.  We charge any write-down of the propertyat the time of acquisition to the allowance for loan losses.  Subsequent gains and losses are included innon-interest income and non-interest expense. Real estate acquired through foreclosure increased $3.9 million to $5.6million at September 30, 2008.  Theincrease was primarily the result of three commercial credit relationshipstotaling $1.3 million, $1.2 million and $1.1 million that were transferredduring the 2008 period.

 

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Thefollowing table provides information with respect to non-performing assets forthe periods indicated.

 
| ** **                                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(Dollar in thousands)**                                  | ** ** | **2008**               | ** ** | **2007**              | ** ** |
| ** **                                                           | ** ** | ** **             | ** ** | ** **            | ** ** |
| Restructured                                                         |       | $                      | 841        |                  | $          | 2,335 |   |
| Past due 90 days  still on accrual                                   |       | —                 |       | —                |       |
| Loans on  non-accrual status                                         |       | 11,461                 |       | 6,554                 |       |
| Total  non-performing loans                                          |       | 12,302                 |       | 8,889                 |       |
|                                                                 |       |                   |       |                  |       |
| Real estate  acquired through foreclosure                            |       | 5,649                  |       | 1,749                 |       |
| Other  repossessed assets                                            |       | 91                     |       | 52                    |       |
| Total  non-performing assets                                         |       | $                      | 18,042     |                  | $          | 10,690 |   |
|                                                                 |       |                   |       |                  |       |
| Interest income  that would have been earned on non-performing loans |       | $                      | 845        |                  | $          | 696 |   |
| Interest income  recognized on non-performing loans                  |       | 93                     |       | 188                   |       |
| Ratios: Non-performing  loans to total loans                         |       |                   |       |                  |       |
| (excluding loans  held for sale)                                     |       | 1.41                   | %          | 1.16                  | %          |
| Non-performing  assets to total loans                                |       |                   |       |                  |       |
| (excluding loans  held for sale)                                     |       | 2.07                   | %          | 1.39                  | %          |

 

Non-performing loans increased $3.4 million to $12.3 million at September 30,2008 compared to $8.9 million at December 31, 2007.  The increase in non-accrual loans consistprimarily of two credit relationships totaling $4.1 million and $751,000. Thesecredit relationships are well secured by real estate and we have providedadequate allowance based on current information.

 

Non-performing assets for the 2008 period include $841,000 inrestructured commercial, mortgage and consumer loans.  Restructured loans primarily consist of fourcredit relationships with balances of $298,000, $219,000, $141,000 and$120,000.   The terms of these loans havebeen renegotiated to reduce the rate of interest and extend the term, thusreducing the amount of cash flow required from the borrower to service theloans. The borrowers are currently meeting the terms of the restructuredloans.  The decrease in restructuredloans from December 31, 2007 was primarily due to the removal of onecredit relationship totaling $2.0 million from the restructured loan categorysince the terms of the loan are now substantially equivalent to terms on whichloans with comparable risks are being made and the borrower has performed perthe terms of the contract.

 

**Investment Securities**

 

Intereston securities provides us our largest source of interest income after intereston loans, constituting 3.2% of the total interest income for the nine monthsended September 30, 2008.  Thesecurities portfolio serves as a source of liquidity and earnings andcontributes to the management of interest rate risk.  We have the authority to invest in varioustypes of liquid assets, including short-term United States Treasury obligationsand securities of various federal agencies, obligations of states and politicalsubdivisions, corporate bonds, certificates of deposit at insured savings andloans and banks, bankers’ acceptances, and federal funds.  We may also invest a portion of our assets incertain commercial paper and corporate debt securities.  We are also authorized to invest in mutualfunds and stocks whose assets conform to the investments that we are authorizedto make directly. The available-for-sale and held-to-maturity investmentportfolios decreased by $14.9 million during the 2008 period as securities werecalled for redemption in accordance with their terms due to decreasingrates.  The FSB Bancshares, Inc.acquisition contributed approximately $2.5 million in held-to-maturity federalagencies and obligations of states and political subdivisions.  We also purchased $524,000 in equitysecurities during the September 2008 period.

 

We review all unrealizedlosses at least on a quarterly basis to determine whether the losses are otherthan temporary and more frequently when economic or market concerns warrantsuch evaluation. We consider the length of time and the extent to which thefair value has been less than cost, the financial condition and near-termprospects of the issuer, and our intent and ability to retain the investment inthe issuer for a period of time sufficient to allow for any anticipatedrecovery in fair value.  In analyzing anissuer’s financial condition, we may consider whether the securities are issuedby the federal government or its agencies, whether downgrades by bond ratingagencies have occurred, and the results of reviews of the issuer’s financial condition.

 

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The unrealized losses on ourtemporarily impaired debt securities are a result of changes in interest ratesfor fixed-rate securities where the interest rate received is less than thecurrent rate available for new offerings of similar securities.   Because the decline in market value isattributable to changes in interest rates and not credit quality, and becausewe have the ability and intent to hold these investments until recovery of fairvalue, which may be maturity, we do not consider these investments to beother-than-temporarily impaired at September 30, 2008.

 

Wehave evaluated the decline in the fair value of our trust preferred securities,which is directly related to the credit and liquidity crisis being experiencedin the financial services industry over the past year.   Thetrust preferred securities market is currently inactive making the valuation oftrust preferred securities very difficult.  The trust preferredsecurities are valued by management using unobservable inputs (i.e., Level 3inputs under SFAS No. 157) through a discounted cash flow analysis aspermitted under SFAS 157 and using the expected cash flows appropriatelydiscounted using present value techniques.   Refer to Note 6 — FairValue for more information.

 

All of our trust preferredsecurities remain investment grade with the exception of PreTSL XXI and havecontinued to pay interest as scheduled through September 30, 2008, and areexpected to continue paying interest as scheduled.  We believe thecash flows of our trust preferred securities, as discounted, appropriatelyreflect the estimated fair value of the securities.  Management hasanalyzed this portfolio to determine whether the decline is other thantemporary and has concluded that only temporary impairment exists. SeeNote 2 – Securities for more information.  Management willcontinue to evaluate these securities for impairmentquarterly.  Under U.S. generally accepted accounting principles, wehave reflected the current period temporary fair value decline in stockholders’equity through comprehensive income.

 

We recognized another-than-temporary impairment charge of $216,000 during the second quarter oncertain equity securities with a cost basis of $840,000. Management believesthis impairment was primarily attributable to current economic conditions.Since recovery does not appear likely in the near future, we recognized theimpairment losses. Previously, we recognized the decline in market value ofthese equity securities in stockholders’ equity through comprehensiveincome.  We continue to monitor theseholdings.

 

###### **Deposits**

###### ** **

Werely primarily on providing excellent customer service and long-standingrelationships with customers to attract and retain deposits. Market interestrates and rates on deposit products offered by competing financial institutionscan significantly affect our ability to attract and retain deposits.  In conjunction with our initiatives to expandand enhance our retail branch network, we emphasize growing our customerchecking account base to better enhance profitability and franchise value.  Total deposits increased $87.7 million yearto date compared to December 31, 2007. The recent acquisition of FSBBancshares, Inc. contributed approximately $55.8 million in deposits.   Retail andcommercial deposits increased $105.7 million which was offset by an $18.0million decrease in public funds and brokered certificates for the 2008 period.  Brokered deposits were $15.4 million at September 30, 2008compared to $24.3 million at December 31, 2007.

 

Thefollowing table breaks down our deposits.

 
| ** **               | ** ** | **September 30,**  | ** ** | **December 31,** | ** ** |
|--------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2008**                | ** ** | **2007**              | ** ** |
| ** **               | ** ** | **(In Thousands)** | ** ** |
|                     |       |                    |       |                  |       |
| Non-interest  bearing    |       | $                       | 63,051     |                  | $          | 46,978 |   |
| NOW demand               |       | 98,900                  |       | 79,133                |       |
| Savings                  |       | 106,295                 |       | 91,249                |       |
| Money market             |       | 42,428                  |       | 49,306                |       |
| Certificates of  deposit |       | 466,247                 |       | 422,577               |       |
|                     |       | $                       | 776,921    |                  | $          | 689,243 |   |

 

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**Short-Term Borrowings**

 

We have the ability to obtain short-term borrowings,consisting of federal funds purchased and securities sold under agreements torepurchase.  We had short-term borrowingsof $65.3 million and $68.2 million from the FHLB of Cincinnati at September 30,2008 and 2007.  These borrowings averageda rate of 2.59% and 5.50% for 2008 and 2007.

 

**Advances from Federal Home Loan Bank**

 

Deposits are the primary source of funds forour lending and investment activities and for our general businesspurposes.  We can also use advances(borrowings) from the Federal Home Loan Bank (FHLB) of Cincinnati to compensatefor reductions in deposits or deposit inflows at less than projectedlevels.  Advances from the FHLB aresecured by our stock in the FHLB, certain securities, certain commercial realestate loans and substantially all of our first mortgage, multi-family and openend home equity loans.  At September 30,2008 we had $53.0 million in advances outstanding from the FHLB and thecapacity to increase our borrowings an additional $38.4 million.

 

**SubordinatedDebentures**

 

On June 24, 2008, FirstFederal Statutory Trust III, an unconsolidated trust subsidiary of FirstFinancial Service Corporation, issued $8.0 million in trust preferredsecurities.  The trust loaned theproceeds of the offering to us in exchange for junior subordinated deferrable interestdebentures which we used to finance the purchase of FSB Bancshares, Inc.  In accordance with FASB Interpretation 46,the trust is not consolidated with our financial statements but rather thesubordinated debentures are shown as a liability.  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 paymentson the subordinated debt from time to time for a period not to exceed fiveconsecutive years.  The subordinateddebentures are considered as Tier I capital for the Corporation under currentregulatory guidelines.

 

In 2002, another trust weformed completed a private placement of 10,000 shares of cumulative trustpreferred securities with a liquidation preference of $1,000 per security for atotal outstanding of $10.0 million. These securities pay distributions of interest. On March 26, 2007we called the $10.0 million in subordinated debentures adjustable quarterly atLIBOR plus 360 basis points (8.97% on March 26, 2007) and issued new 30year cumulative trust preferred securities 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 deferinterest payments on the subordinated debt from time to time for a period notto exceed five consecutive years. The subordinated debentures are considered asTier I capital for the Corporation under current regulatory guidelines.

 

The trust loaned theproceeds of the offering to us in exchange for junior subordinated deferrableinterest debentures. In accordance with FASB Interpretation 46, the trust isnot consolidated with our financial statements but rather the subordinateddebentures are shown as a liability.

 

##### **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. We maintain an investment and funds management policy, which 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 four of our correspondent banks. Two of the lines are for $15 million each and the other two are for $5 million each.  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, 2008, we had an unused approved line of credit in the amount of $97.0 million and sufficient collateral available to borrow, approximately, an additional $38.4 million in advances from

 

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the FHLB.**** We believe our sources of liquidity are adequate to meet expected cash needs for the foreseeable future.

 

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 primary source offunding for the Corporation has been dividends and returns of investment fromthe Bank. Kentucky banking laws limit the amount of dividends that may be paidto the Corporation by the Bank without prior approval of the KOFI.  Under these laws, the amount of dividendsthat 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 precedingtwo years, less any dividends declared during those periods.  At September 30, 2008, the Bank hadapproximately $13.9 million of retained earnings that could be used to paydividends without prior regulatory approval. Because of these limitations, consolidated cash flows as presented inthe consolidated statements of cash flows may not represent cash immediatelyavailable to the Corporation.  During2008, the Bank declared and paid dividends of $9.5 million to theCorporation.  Included in the totaldividend payment was $6.0 million in dividends that were used to finance thepurchase of FSB Bancshares, Inc.**

###### ** **

##### **CAPITAL**

##### ** **

Stockholders’ equityincreased $996,000 for the period ended September 30, 2008 compared to December 31,2007 primarily due to net income earned during the period.  This increase was reduced by cash dividendsdeclared and the net change in unrealized losses on securitiesavailable-for-sale during the period. Average stockholders’ equity to average assets ratio decreased to 8.21%for the nine month period ended September 30, 2008 compared to 8.59% for2007.

 

During the first nine months of 2008, we did not purchase any shares ofour own common stock.  The current repurchaseprogram authorizes the repurchase of 398,601 shares from time-to-time if marketconditions are deemed favorable.  The repurchaseprogram will remain effective until the number of shares authorized isrepurchased or until the program expires.  As of September 30,2008, 242,560 shares could be repurchased under the current stock repurchaseprogram.

 

Each of the federal bank regulatory agencies hasestablished minimum leverage capital requirements for banks. Banks mustmaintain a minimum ratio of Tier 1 capital to adjusted average quarterly assetsranging from 3% to 5%, subject to federal bank regulatory evaluation of anorganization’s overall safety and soundness. We intend to maintain a capital position that meets or exceeds the “wellcapitalized” requirements as defined for banks by the FDIC.  The following table shows the ratios of Tier1 capital and total capital to risk-adjusted assets and the leverage ratios forthe Corporation and the Bank as of September 30, 2008.

 

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| ** **                                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **To Be Considered** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Well Capitalized**      | ** ** |
| ** **                                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Under Prompt**          | ** ** |
| ** **                                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Correction** | ** ** |
| ** **                                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(Dollars in thousands)**                 | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**      | ** ** | **Amount**                     | ** ** | **Ratio** | ** ** |
| **As of September 30, 2008:**    |       |       |       |                       |       |                       |       |           |       |                           |       |   |   |
| Total risk-based  capital (to risk- weighted assets) |       |       |       |                       |       |                       |       |           |       |                           |       |   |   |
| Consolidated                                         |       | $          | 90,795     |                       | 10.6       | %                          | $          | 68,660         |       | 8.0                            | %          | N/A |   | N/A |   |
| Bank                                                 |       | 89,136     |       | 10.4                       |       | 68,533                     |       | 8.0            |       | $                              | 85,666     |   | 10 | % |
| Tier I capital  (to risk-weighted assets)            | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 80,288     |       | 9.4                        |       | 34,330                     |       | 4.0            |       | N/A                            |       | N/A |   |
| Bank                                                 |       | 78,621     |       | 9.2                        |       | 34,266                     |       | 4.0            |       | 51,399                         |       | 6 | % |
| Tier I capital  (to average assets)                  | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 80,288     |       | 8.3                        |       | 38,668                     |       | 4.0            |       | N/A                            |       | N/A |   |
| Bank                                                 |       | 78,621     |       | 8.1                        |       | 38,631                     |       | 4.0            |       | 48,289                         |       | 5 | % |
|                                                      |            |            |            |                            |            |                            |            |                |            |                                |            |  |  |  |  |  |

 
| ** **                                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **To Be Considered** | ** ** |
|------------------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------|------------|--------------------------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Well Capitalized**      | ** ** |
| ** **                                           | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Under Prompt**          | ** ** |
| ** **                                           | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Correction** | ** ** |
| ** **                                           | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **(Dollars in thousands)**                 | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**      | ** ** | **Amount**                     | ** ** | **Ratio** | ** ** |
| **As of December 31, 2007:**     |       |       |       |                       |       |                       |       |           |       |                           |       |   |   |
| Total risk-based  capital (to risk- weighted assets) |       |       |       |                       |       |                       |       |           |       |                           |       |   |   |
| Consolidated                                         |       | $          | 83,310     |                       | 10.9       | %                          | $          | 61,405         |       | 8.0                            | %          | N/A |   | N/A |   |
| Bank                                                 |       | 80,176     |       | 10.5                       |       | 61,220                     |       | 8.0            |       | $                              | 76,526     |   | 10.0 |   |
| Tier I capital  (to risk-weighted assets)            | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 75,388     |       | 9.8                        |       | 30,703                     |       | 4.0            |       | N/A                            |       | N/A |   |
| Bank                                                 |       | 72,126     |       | 9.4                        |       | 30,610                     |       | 4.0            |       | 45,915                         |       | 6.0 |   |
| Tier I capital  (to average assets)                  | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Consolidated                                         |       | 75,388     |       | 8.7                        |       | 34,661                     |       | 4.0            |       | N/A                            |       | N/A |   |
| Bank                                                 |       | 72,126     |       | 8.3                        |       | 34,661                     |       | 4.0            |       | 43,326                         |       | 5.0 |   |
|                                                      |            |            |            |                            |            |                            |            |                |            |                                |            |  |  |  |  |  |

 

###### **Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

###### ** **

###### **Asset/Liability Managementand Market Risk**

###### ** **

To minimize the volatility of net interest income and exposure toeconomic loss that may result from fluctuating interest rates, we manage ourexposure to adverse changes in interest rates through asset and liabilitymanagement activities within guidelines established by our Asset LiabilityCommittee (“ALCO”).  The ALCO, whichincludes senior management representatives, has the responsibility forapproving and ensuring compliance with asset/liability managementpolicies.  Interest rate risk is theexposure to adverse changes in the net interest income as a result of marketfluctuations in interest rates.  TheALCO, on an ongoing basis, monitors interest rate and liquidity risk in orderto implement appropriate funding and balance sheet strategies.  Management considers interest rate risk to beour most significant market risk.

 

We utilize an earnings simulation model to analyze netinterest income sensitivity.  We thenevaluate potential changes in market interest rates and their subsequenteffects on net interest income.  Themodel projects the effect of instantaneous movements in interest rates of both100 and 200 basis points.  We alsoincorporate assumptions based on the historical behavior of our deposit ratesand balances in relation to changes in interest rates into the model.  These assumptions are inherently uncertainand, as a result, the model cannot precisely measure future net interest incomeor precisely predict the impact of fluctuations in market interest rates on netinterest income.  Actual results willdiffer from the model’s simulated results due to timing, magnitude andfrequency of interest rate changes as well as changes in market conditions andthe application and timing of various management strategies.

 

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Our interest sensitivity profile was asset sensitiveat September 30, 2008 and December 31, 2007.  Given a sustained 100 basis point decrease inrates, our base net interest income would decrease by an estimated****1.91% at September 30, 2008 comparedto a decrease of 1.10% at December 31, 2007. ** **Given a 100 basis pointincrease in interest rates our base net interest income would increase by an****estimated 2.09% at September 30, 2008compared to an increase of 1.09% at December 31, 2007.

 

Our interest sensitivity at any point in time willbe affected by a number of factors. These factors include the mix of interest sensitive assets andliabilities, their relative pricing schedules, market interest rates, depositgrowth, loan growth, decay rates and prepayment speed assumptions.

 

We use various asset/liability strategies to managethe re-pricing characteristics of our assets and liabilities designed to ensurethat exposure to interest rate fluctuations is limited within our guidelines ofacceptable levels of risk-taking.  Asdemonstrated by the September 30, 2008 and December 31, 2007sensitivity tables, our balance sheet has an asset sensitive position. Thismeans that our earning assets, which consist of loans and investmentsecurities, will change in price at a faster rate than our deposits andborrowings.  Therefore, if short terminterest rates increase, our net interest income will increase.  Likewise, if short term interest ratesdecrease, our net interest income will decrease.

 

Our sensitivity to interest rate changes ispresented based on data as of September 30, 2008 and December 31,2007 annualized to a one year period.

 
| ** **                           | ** ** | **September 30, 2008** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|
| ** **                           | ** ** | **Decrease in Rates**  | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                           | ** ** | **200**                          | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| **(Dollars in thousands)** | ** ** | **Basis Points**            | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
| ** **                           |       |                             |       |   |   |   |   |   |   |   |   |
| **Projected  interest income**       |       |                             |       |   |   |   |   |   |   |   |   |
| Loans                                |       | $                                | 52,411     |   | $ | 53,871 |   | $ | 55,318 |   | $ | 56,862 |   | $ | 58,390 |   |
| Investments                          |       | 1,564                            |       | 1,651 |   | 1,725 |   | 1,806 |   | 1,878 |   |
| **Total  interest income**           |       | 53,975                           |       | 55,522 |   | 57,043 |   | 58,668 |   | 60,268 |   |
|                                 |       |                             |       |   |   |   |   |   |   |   |   |
| **Projected  interest expense**      |       |                             |       |   |   |   |   |   |   |   |   |
| Deposits                             |       | 18,144                           |       | 18,742 |   | 19,280 |   | 19,863 |   | 20,418 |   |
| Borrowed funds                       |       | 5,018                            |       | 4,650 |   | 5,008 |   | 5,364 |   | 5,719 |   |
| **Total  interest expense**          |       | 23,162                           |       | 23,392 |   | 24,288 |   | 25,227 |   | 26,137 |   |
|                                 |       |                             |       |   |   |   |   |   |   |   |   |
| **Net  interest income**             |       | $                                | 30,813     |   | $ | 32,130 |   | $ | 32,755 |   | $ | 33,441 |   | $ | 34,131 |   |
| Change from base                     |       | $                                | (1,942     | ) | $ | (625 | ) | ** ** |   | $ | 686 |   | $ | 1,376 |   |
| % Change from  base                  |       | (5.93                            | )%         | (1.91 | )% | ** ** |   | 2.09 | % | 4.20 | % |

 
| ** **                           | ** ** | **December 31, 2007** | ** ** |
|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Decrease in Rates** | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                           | ** ** | **200**                         | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| **(Dollars in thousands)** | ** ** | **Basis Points**           | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
| ** **                           |       |                            |       |   |   |   |   |   |   |   |   |
| **Projected  interest income**       |       |                            |       |   |   |   |   |   |   |   |   |
| Loans                                |       | $                               | 54,208     |   | $ | 55,624 |   | $ | 57,011 |   | $ | 58,344 |   | $ | 59,644 |   |
| Investments                          |       | 2,319                           |       | 2,351 |   | 2,376 |   | 2,407 |   | 2,439 |   |
| **Total  interest income**           |       | 56,527                          |       | 57,975 |   | 59,387 |   | 60,751 |   | 62,083 |   |
|                                 |       | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Projected  interest expense**      |       | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deposits                             |       | 20,995                          |       | 21,856 |   | 22,733 |   | 23,572 |   | 24,485 |   |
| Borrowed funds                       |       | 3,481                           |       | 3,656 |   | 3,829 |   | 3,997 |   | 4,166 |   |
| **Total  interest expense**          |       | 24,476                          |       | 25,512 |   | 26,562 |   | 27,569 |   | 28,651 |   |
|                                 |       | ** **                      |       |   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net  interest income**             |       | $                               | 32,051     |   | $ | 32,463 |   | $ | 32,825 |   | $ | 33,182 |   | $ | 33,432 |   |
| Change from base                     |       | $                               | (774       | ) | $ | (362 | ) | ** ** |   | $ | 357 |   | $ | 607 |   |
| % Change from  base                  |       | (2.36                           | )%         | (1.10 | )% | ** ** |   | 1.09 | % | 1.85 | % |

 

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###### **Item 4.  CONTROLS AND PROCEDURES**

###### ** **

*Evaluation of disclosure controls and procedures*

 

Ourmanagement, with the participation of our Chief Executive Officer and our ChiefFinancial Officer, evaluated the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this quarterly report on Form10-Q to ensure that information we are required to disclose in reports that wefile or submit under the Securities Exchange Act of 1934 is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms. Based on this evaluation,our Chief Executive Officer and our Chief Financial Officer have concluded thatour disclosure controls and procedures related to the application of SFAS No.114 “Accounting by Creditors for Impairment of a Loan” were not effective as ofthe end of the period covered by this Quarterly Report on Form 10-Q for acertain transaction. Specifically, this transaction related to the use of awrong value obtained from an appraisal on one commercial real estate loan indetermining the amount of impairment change needed to be taken by the Company.  This transaction was identified afterdiscussion with the Company’s independent registered public accounting firm.Management has made modifications to the internal control procedures fordetermining write-downs on impaired loans to remediate this deficiency and anticipatesthat such controls will operate effectively for the remainder of 2008.

 

*Limitations on the Effectiveness of Controls*

 

A control system, no matter how well designed andoperated, can provide only reasonable, not absolute, assurance that the controlsystem’s objectives will be met. Further, the design of a control system must reflect the fact that thereare resource constraints, and the benefits of controls must be consideredrelative to their costs.  Because of theinherent limitations in all control systems, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, with our company have been detected. These inherent limitations include the realities that judgments indecision making can be faulty, that breakdowns can occur because of simpleerrors or mistakes, and that controls can be circumvented by the acts ofindividuals or groups.  Because of theinherent limitations in a cost effective control system, misstatements due toerror or fraud may occur and not be detected.

 

*Changes in internal control over financial reporting*

 

Therewas no change in our internal control over financial reporting that occurredduring the period covered by this quarterly report on Form 10-Q that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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##### **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**                                                                                                                                                                                                                    |
|         |       |                                                                                                                                                                                                                                |
|         |       | We  did not have any changes to our risk factors previously disclosed in our  Annual Report on Form 10-K for the year ended December 31, 2007.                                                                            |
|         |       |                                                                                                                                                                                                                                |
| **Item 2.**  | ** ** | **Unregistered Sales of Securities and Use of Proceeds**                                                                                                                                                                            |
|         |       |                                                                                                                                                                                                                                |
|         |       | (e)   Issuer Purchases of Equity Securities                                                                                                                                                                                    |
|         |       |                                                                                                                                                                                                                                |
|         |       | We did not repurchase any shares of our common stock during the quarter ended September 30, 2008.                                                                                                                              |
|         |       |                                                                                                                                                                                                                                |
| **Item 3.**  | ** ** | **Defaults Upon Senior Securities**                                                                                                                                                                                                 |
|         |       |                                                                                                                                                                                                                                |
|         |       | Not  Applicable                                                                                                                                                                                                                     |
|         |       |                                                                                                                                                                                                                                |
| **Item 4.**  | ** ** | **Submission of Matters to a Vote of Security Holders**                                                                                                                                                                             |
|         |       |                                                                                                                                                                                                                                |
|         |       | None                                                                                                                                                                                                                                |
|         |       |                                                                                                                                                                                                                                |
| **Item 5.**  | ** ** | **Other Information**                                                                                                                                                                                                               |
| ** **   | ** ** | ** **                                                                                                                                                                                                                          |
|         |       | None                                                                                                                                                                                                                                |
|         |       |                                                                                                                                                                                                                                |
| **Item 6.**  | ** ** | **Exhibits:**                                                                                                                                                                                                                       |
|         |       |                                                                                                                                                                                                                                |
|         |       | 31.1                                                                                                                                                                                                                                | Certification  of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act |
|         |       |                                                                                                                                                                                                                                |   |
|         |       | 31.2                                                                                                                                                                                                                                | Certification  of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act |
|         |       |                                                                                                                                                                                                                                |   |
|         |       | 32                                                                                                                                                                                                                                  | 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) |

 

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**FIRST FINANCIAL SERVICE CORPORATION**

 

## **SIGNATURES**

## ** **

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
| Date:  November 10, 2008 | By:    | /s/  B. Keith Johnson               |
|-------------------------------|--------|-------------------------------------|
|                          |   | B.  Keith Johnson                   |
|                          |   | Chief  Executive Officer            |
|                          |   |                                |
|                          |   |                                |
| Date:  November 10, 2008 | By:    | /s/  Steven M. Zagar                |
|                          |   | Steven M. Zagar                     |
|                          |   | Chief  Financial Officer & |
|                          |   | Principal  Accounting Officer       |

 

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## **INDEX TO EXHIBITS**

## ** **

| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                             |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                        |
| 31.1                 |       | Certification  of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                                |
|                 |       |                                                                                                                                                                                        |
| 31.2                 |       | Certification  of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                                |
|                 |       |                                                                                                                                                                                        |
| 32                   |       | 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) |

 

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