UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C.  20549





FORM
10-Q


(Mark
One)





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





For
the quarterly period ended June 30, 2010





OR





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





Commission
File Number 0-18832





First
Financial Service Corporation


(Exact
Name of Registrant as specified in its charter)





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





2323
      Ring Road
            
            (270)
      765-2131Elizabethown,
      Kentucky 42701
            
            (Registrant's
      telephone number,(Address
      of principal executive offices)
            
            including
      area code)(Zip
      Code)





(270)
765-2131


(Registrant's
telephone number, including area code)





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





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files). Yes  ̈  No
  ̈





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





Large Accelerated Filer  ̈
            
            Accelerated Filerx
            
            Non-Accelerated Filer  ̈
            
            Smaller ReportingCompany  ̈(Do not check if a smaller
              reporting company)





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





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





Class
              
              Outstanding as of July 31, 2010Common
      Stock
              
              4,725,823shares





FIRST
FINANCIAL SERVICE CORPORATION


FORM
10-Q


TABLE
OF CONTENTS





PART I – FINANCIAL
      INFORMATIONPreliminary
      Note Regarding Forward-Looking Statements
                3Item
      1.
                Consolidated
      Financial Statements and Notes to Consolidated Financial
      Statements
                4Item
      2.
                Management's
      Discussion and Analysis of Financial Condition and Results of
      Operations
                23Item
      3.
                Quantitative
      and Qualitative Disclosures about Market Risk
                38Item
      4.
                Controls
      and Procedures
                40PART II – OTHER
      INFORMATION
                40Item
      1.
                Legal
      Proceedings
                40Item
      1A.
                Risk
      Factors
                40Item
      2.
                Unregistered
      Sales of Equity Securities and Use of Proceeds
                41Item
      3.
                Defaults
      upon Senior Securities
                41Item
      4.
                Reserved
                41Item
      5.
                Other
      Information
                41Item
      6.
                Exhibits
                41SIGNATURES
                
                42


2


PRELIMINARY
NOTE REGARDING


FORWARD-LOOKING
STATEMENTS





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





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





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


3





Item 1.
              FIRST
      FINANCIAL SERVICE CORPORATIONConsolidated
      Balance Sheets(Unaudited)





June 30,
                    
                    
                    December 31,(Dollars in thousands, except share data)
                    
                    2010
                    
                    
                    2009ASSETS:Cash
      and due from banks
                    
                    $
                    14,060
                    
                    
                    $
                    21,253Interest
      bearing deposits
                    
                    
                    60,685
                    
                    
                    
                    77,280Total
      cash and cash equivalents
                    
                    
                    74,745
                    
                    
                    
                    98,533Securities
      available-for-sale
                    
                    
                    144,761
                    
                    
                    
                    45,764Securities
      held-to-maturity, fair value of $381 Jun (2010) and $1,176 Dec
      (2009)
                    
                    
                    378
                    
                    
                    
                    1,167Total
      securities
                    
                    
                    145,139
                    
                    
                    
                    46,931Loans
      held for sale
                    
                    
                    14,997
                    
                    
                    
                    8,183Loans,
      net of unearned fees
                    
                    
                    940,631
                    
                    
                    
                    994,926Allowance
      for loan losses
                    
                    
                    (20,953
                    )
                    
                    
                    (17,719
                    )Net
      loans
                    
                    
                    934,675
                    
                    
                    
                    985,390Federal
      Home Loan Bank stock
                    
                    
                    8,515
                    
                    
                    
                    8,515Cash
      surrender value of life insurance
                    
                    
                    9,181
                    
                    
                    
                    9,008Premises
      and equipment, net
                    
                    
                    32,325
                    
                    
                    
                    31,965Real
      estate owned:Acquired
      through foreclosure
                    
                    
                    14,703
                    
                    
                    
                    8,428Held
      for development
                    
                    
                    45
                    
                    
                    
                    45Other
      repossessed assets
                    
                    
                    151
                    
                    
                    
                    103Core
      deposit intangible
                    
                    
                    1,148
                    
                    
                    
                    1,300Accrued
      interest receivable
                    
                    
                    5,907
                    
                    
                    
                    5,658Deferred
      income taxes
                    
                    
                    3,969
                    
                    
                    
                    4,515Prepaid
      FDIC premium
                    
                    
                    5,747
                    
                    
                    
                    7,022Other
      assets
                    
                    
                    2,959
                    
                    
                    
                    2,091TOTAL
      ASSETS
                    
                    $
                    1,239,209
                    
                    
                    $
                    1,209,504LIABILITIES
      AND STOCKHOLDERS' EQUITYLIABILITIES:Deposits:Non-interest
      bearing
                    
                    $
                    70,204
                    
                    
                    $
                    63,950Interest
      bearing
                    
                    
                    1,009,081
                    
                    
                    
                    985,865Total
      deposits
                    
                    
                    1,079,285
                    
                    
                    
                    1,049,815Short-term
      borrowings
                    
                    
                    595
                    
                    
                    
                    1,500Advances
      from Federal Home Loan Bank
                    
                    
                    52,596
                    
                    
                    
                    52,745Subordinated
      debentures
                    
                    
                    18,000
                    
                    
                    
                    18,000Accrued
      interest payable
                    
                    
                    289
                    
                    
                    
                    360Accounts
      payable and other liabilities
                    
                    
                    1,936
                    
                    
                    
                    1,952TOTAL
      LIABILITIES
                    
                    
                    1,152,701
                    
                    
                    
                    1,124,372Commitments
      and contingent liabilities
                    
                    
                    -
                    
                    
                    
                    -STOCKHOLDERS'
      EQUITY:Serial
      preferred stock, $1 par value per share; authorized 5,000,000 shares;
      issued and outstanding, 20,000 shares with a liquidation preference of
      $20,000
                    
                    
                    19,808
                    
                    
                    
                    19,781Common
      stock, $1 par value per share; authorized 10,000,000 shares; issued and
      outstanding, 4,718,334 shares Jun 2010, and 4,709,839 shares Dec
      2009
                    
                    
                    4,718
                    
                    
                    
                    4,710Additional
      paid-in capital
                    
                    
                    35,099
                    
                    
                    
                    34,984Retained
      earnings
                    
                    
                    26,886
                    
                    
                    
                    26,720Accumulated
      other comprehensive loss
                    
                    
                    (3
                    )
                    
                    
                    (1,063
                    )TOTAL
      STOCKHOLDERS' EQUITY
                    
                    
                    86,508
                    
                    
                    
                    85,132TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
                    
                    $
                    1,239,209
                    
                    
                    $
                    1,209,504





See
notes to the unaudited consolidated financial statements.


4





FIRST
FINANCIAL SERVICE CORPORATION


Consolidated
Statements of Income


(Unaudited)





Three Months Ended
                
                
                Six Months Ended(Dollars in thousands, except per share data)
                
                June 30,
                
                
                June 30,2010
                
                
                2009
                
                
                2010
                
                
                2009Interest
      and Dividend Income:Loans,
      including fees
                
                $
                14,267
                
                
                $
                14,155
                
                
                $
                28,314
                
                
                $
                28,099Taxable
      securities
                
                
                878
                
                
                
                305
                
                
                
                1,371
                
                
                
                613Tax
      exempt securities
                
                
                202
                
                
                
                118
                
                
                
                373
                
                
                
                224Total
      interest income
                
                
                15,347
                
                
                
                14,578
                
                
                
                30,058
                
                
                
                28,936Interest
      Expense:Deposits
                
                
                4,890
                
                
                
                4,346
                
                
                
                9,759
                
                
                
                8,846Short-term
      borrowings
                
                
                11
                
                
                
                47
                
                
                
                32
                
                
                
                90Federal
      Home Loan Bank advances
                
                
                596
                
                
                
                600
                
                
                
                1,189
                
                
                
                1,197Subordinated
      debentures
                
                
                331
                
                
                
                329
                
                
                
                658
                
                
                
                658Total
      interest expense
                
                
                5,828
                
                
                
                5,322
                
                
                
                11,638
                
                
                
                10,791Net
      interest income
                
                
                9,519
                
                
                
                9,256
                
                
                
                18,420
                
                
                
                18,145Provision
      for loan losses
                
                
                3,274
                
                
                
                1,913
                
                
                
                5,026
                
                
                
                3,958Net
      interest income after provision for loan losses
                
                
                6,245
                
                
                
                7,343
                
                
                
                13,394
                
                
                
                14,187Non-interest
      Income:Customer
      service fees on deposit accounts
                
                
                1,739
                
                
                
                1,645
                
                
                
                3,264
                
                
                
                3,122Gain
      on sale of mortgage loans
                
                
                415
                
                
                
                355
                
                
                
                714
                
                
                
                532Loss
      on sale of investments
                
                
                -
                
                
                
                -
                
                
                
                (23
                )
                
                
                -Total
      other-than-temporary impairment losses
                
                
                (11
                )
                
                
                (245
                )
                
                
                (183
                )
                
                
                (615
                )Portion
      of loss recognized in other comprehensive income(before
    taxes)
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                215Net
      impairment losses recognized in earnings
                
                
                (11
                )
                
                
                (245
                )
                
                
                (183
                )
                
                
                (400
                )Loss
      on sale and write downs of real estate acquired through
      foreclosure
                
                
                (438
                )
                
                
                (233
                )
                
                
                (464
                )
                
                
                (250
                )Brokerage
      commissions
                
                
                107
                
                
                
                99
                
                
                
                200
                
                
                
                192Other
      income
                
                
                369
                
                
                
                469
                
                
                
                811
                
                
                
                897Total
      non-interest income
                
                
                2,181
                
                
                
                2,090
                
                
                
                4,319
                
                
                
                4,093Non-interest
      Expense:Employee
      compensation and benefits
                
                
                3,905
                
                
                
                4,149
                
                
                
                7,995
                
                
                
                8,151Office
      occupancy expense and equipment
                
                
                768
                
                
                
                808
                
                
                
                1,572
                
                
                
                1,656Marketing
      and advertising
                
                
                225
                
                
                
                245
                
                
                
                450
                
                
                
                510Outside
      services and data processing
                
                
                668
                
                
                
                795
                
                
                
                1,398
                
                
                
                1,588Bank
      franchise tax
                
                
                566
                
                
                
                257
                
                
                
                916
                
                
                
                521FDIC
      insurance premiums
                
                
                694
                
                
                
                788
                
                
                
                1,354
                
                
                
                967Amortization
      of core deposit intangible
                
                
                88
                
                
                
                101
                
                
                
                152
                
                
                
                202Other
      expense
                
                
                1,720
                
                
                
                1,301
                
                
                
                3,071
                
                
                
                2,632Total
      non-interest expense
                
                
                8,634
                
                
                
                8,444
                
                
                
                16,908
                
                
                
                16,227Income/(loss)
      before income taxes
                
                
                (208
                )
                
                
                989
                
                
                
                805
                
                
                
                2,053Income
      taxes/(benefits)
                
                
                (146
                )
                
                
                274
                
                
                
                112
                
                
                
                577Net
      Income/(loss)
                
                
                (62
                )
                
                
                715
                
                
                
                693
                
                
                
                1,476Less:Dividends
      on preferred stock
                
                
                (250
                )
                
                
                (213
                )
                
                
                (500
                )
                
                
                (480
                )Accretion
      on preferred stock
                
                
                (13
                )
                
                
                (14
                )
                
                
                (27
                )
                
                
                (25
                )Net
      income/(loss) available to common shareholders
                
                $
                (325
                )
                
                $
                488
                
                
                $
                166
                
                
                $
                971Shares
      applicable to basic income/(loss) per common share
                
                
                4,718,021
                
                
                
                4,687,983
                
                
                
                4,716,755
                
                
                
                4,682,683Basic
      income/(loss) per common share
                
                $
                (0.07
                )
                
                $
                0.10
                
                
                $
                0.04
                
                
                $
                0.21Shares
      applicable to diluted income/(loss) per common share
                
                
                4,718,021
                
                
                
                4,726,226
                
                
                
                4,716,755
                
                
                
                4,685,686Diluted
      income/(loss) per common share
                
                $
                (0.07
                )
                
                $
                0.10
                
                
                $
                0.04
                
                
                $
                0.21Cash
      dividends declared per common share
                
                $
                -
                
                
                $
                0.19
                
                
                $
                -
                
                
                $
                0.38





See
notes to the unaudited consolidated financial statements.


5





FIRST
FINANCIAL SERVICE CORPORATION


Consolidated
Statements of Comprehensive Income


(Unaudited)





Three Months Ended
                
                
                Six Months EndedJune 30,
                
                
                June 30,(Dollars in thousands)
                
                2010
                
                
                2009
                
                
                2010
                
                
                2009Net
      Income/Loss)
                
                $
                (62
                )
                
                $
                715
                
                
                $
                693
                
                
                $
                1,476Other
      comprehensive income (loss):Change
      in unrealized gain (loss) on securities available-for-sale
                
                
                1,381
                
                
                
                371
                
                
                
                1,448
                
                
                
                610Change
      in unrealized gain (loss) on securities available-for-sale for which a
      portion of other-than-temporary impairment has been recognized into
      earnings
                
                
                (19
                )
                
                
                -
                
                
                
                (47
                )
                
                
                -Reclassification
      of realized amount on securities available-for-sale losses
      (gains)
                
                
                11
                
                
                
                236
                
                
                
                157
                
                
                
                376Non-credit
      component of other-than-temporary impairment on held-to-maturity
      securities
                
                
                -
                
                
                
                -
                
                
                
                -
                
                
                
                (215
                )Reclassification
      of unrealized loss on held-to-maturity security recognized in
      income
                
                
                20
                
                
                
                -
                
                
                
                49
                
                
                
                -Accretion
      (amortization) of non-credit component of other-than- temorary impairment
      on held-to-maturity securities
                
                
                (1
                )
                
                
                2
                
                
                
                (1
                )
                
                
                2Net
      unrealized gain (loss) recognized in comprehensive income
                
                
                1,392
                
                
                
                609
                
                
                
                1,606
                
                
                
                773Tax
      effect
                
                
                (473
                )
                
                
                (207
                )
                
                
                (546
                )
                
                
                (263
                )Total
      other comphrehensive income (loss)
                
                
                919
                
                
                
                402
                
                
                
                1,060
                
                
                
                510Comprehensive
      Income
                
                $
                857
                
                
                $
                1,117
                
                
                $
                1,753
                
                
                $
                1,986





The
following is a summary of the accumulated other comprehensive income balances,
net of tax:





Balance
                      
                      
                      Current
                      
                      
                      Balanceat
                      
                      
                      Period
                      
                      
                      at12/31/2009
                      
                      
                      Change
                      
                      
                      6/30/2010Unrealized
      gains (losses) on securities available-for-sale
                      
                      $
                      (925
                      )
                      
                      $
                      1,028
                      
                      
                      $
                      103Unrealized
      gains (losses) on held-to-maturity securities for which OTTI has been
      recorded, net of accretion
                      
                      
                      (138
                      )
                      
                      
                      32
                      
                      
                      
                      (106
                      )Total
                      
                      $
                      (1,063
                      )
                      
                      $
                      1,060
                      
                      
                      $
                      (3
                      )





See
notes to the unaudited consolidated financial statements.


6





FIRST
FINANCIAL SERVICE CORPORATION


Consolidated
Statements of Changes in Stockholders' Equity


Six
Months Ended June 30, 2010


(Dollars
In Thousands, Except Per Share Amounts)


(Unaudited)





Shares
                      
                      
                      Amount
                      
                      
                      Additional
                        Paid-in
                      
                      
                      Retained
                      
                      
                      Accumulated
                        Other
                        Comprehensive
                        (Loss),
      Net ofPreferred
                      
                      
                      Common
                      
                      
                      Preferred
                      
                      
                      Common
                      
                      
                      Capital
                      
                      
                      Earnings
                      
                      
                      Tax
                      
                      
                      TotalBalance,
      January 1, 2010
                      
                      
                      20,000
                      
                      
                      
                      4,710
                      
                      
                      $
                      19,781
                      
                      
                      $
                      4,710
                      
                      
                      $
                      34,984
                      
                      
                      $
                      26,720
                      
                      
                      $
                      (1,063
                      )
                      
                      $
                      85,132Net
      income
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      693
                      
                      
                      
                      
                      
                      
                      
                      693Shares
      issued under dividend reinvestment program
                      
                      
                      
                      
                      
                      
                      1
                      
                      
                      
                      
                      
                      
                      
                      1
                      
                      
                      
                      12
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      13Stock
      issued for employee benefit plans
                      
                      
                      
                      
                      
                      
                      7
                      
                      
                      
                      
                      
                      
                      
                      7
                      
                      
                      
                      56
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      63Stock-based
      compensation expense
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      47
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      47Net
      change in unrealized gains (losses) on securities available-for-sale, net
      of tax
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      970
                      
                      
                      
                      970Change
      in unrealized gains (losses) on held-to-maturity securities for which an
      other-than-temporary impairment charge has been recorded, net of
      tax
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      32
                      
                      
                      
                      32Change
      in unrealized gains (losses) on securities available-for-sale for which a
      portion of an other-than-temporary impairment charge has been recognized
      into earnings, net of reclassification and taxes
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      58
                      
                      
                      
                      58Dividends
      on preferred stock
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      
                      (500
                      )
                      
                      
                      
                      
                      
                      
                      (500
                      )Accretion
      of preferred stock discount
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      27
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      (27
                      )
                      
                      
                      -
                      
                      
                      
                      -Balance,
      June 30, 2010
                      
                      
                      20,000
                      
                      
                      
                      4,718
                      
                      
                      $
                      19,808
                      
                      
                      $
                      4,718
                      
                      
                      $
                      35,099
                      
                      
                      $
                      26,886
                      
                      
                      $
                      (3
                      )
                      
                      $
                      86,508





See
notes to the unaudited consolidated financial statements.


7





FIRST
FINANCIAL SERVICE CORPORATION


Consolidated
Statements of Cash Flows


(Dollars
In Thousands)


(Unaudited)





Six Months EndedJune 30,2010
                            
                            
                            2009Operating
      Activities:Net
      income
                            
                            $
                            693
                            
                            
                            $
                            1,476Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for loan losses
                            
                            
                            5,026
                            
                            
                            
                            3,958Depreciation
      on premises and equipment
                            
                            
                            872
                            
                            
                            
                            828Core
      deposit intangible amortization
                            
                            
                            152
                            
                            
                            
                            202Net
      amortization (accretion) available-for-sale
                            
                            
                            (911
                            )
                            
                            
                            128Net
      amortization (accretion) held-to-maturity
                            
                            
                            -
                            
                            
                            
                            7Impairment
      loss on securities available-for-sale
                            
                            
                            134
                            
                            
                            
                            376Impairment
      loss on securities held-to-maturity
                            
                            
                            49
                            
                            
                            
                            24Loss
      on sale of investments available-for-sale
                            
                            
                            23
                            
                            
                            
                            -Gain
      on sale of mortgage loans
                            
                            
                            (714
                            )
                            
                            
                            (532
                            )Origination
      of loans held for sale
                            
                            
                            (55,617
                            )
                            
                            
                            (80,084
                            )Proceeds
      on sale of loans held for sale
                            
                            
                            49,517
                            
                            
                            
                            84,043Stock-based
      compensation expense
                            
                            
                            47
                            
                            
                            
                            52Prepaid
      FDIC premium
                            
                            
                            1,275
                            
                            
                            
                            -Changes
      in:Cash
      surrender value of life insurance
                            
                            
                            (173
                            )
                            
                            
                            (180
                            )Interest
      receivable
                            
                            
                            (249
                            )
                            
                            
                            (64
                            )Other
      assets
                            
                            
                            (868
                            )
                            
                            
                            (963
                            )Interest
      payable
                            
                            
                            (71
                            )
                            
                            
                            (25
                            )Accounts
      payable and other liabilities
                            
                            
                            (16
                            )
                            
                            
                            115Net
      cash from operating activities
                            
                            
                            (831
                            )
                            
                            
                            9,361Investing
      Activities:Sales
      of securities available-for-sale
                            
                            
                            500
                            
                            
                            
                            -Purchases
      of securities available-for-sale
                            
                            
                            (118,689
                            )
                            
                            
                            (18,590
                            )Maturities
      of securities available-for-sale
                            
                            
                            21,504
                            
                            
                            
                            871Maturities
      of securities held-to-maturity
                            
                            
                            788
                            
                            
                            
                            4,974Net
      change in loans
                            
                            
                            46,180
                            
                            
                            
                            (77,961
                            )Net
      purchases of premises and equipment
                            
                            
                            (1,232
                            )
                            
                            
                            (2,725
                            )Net
      cash from investing activities
                            
                            
                            (50,949
                            )
                            
                            
                            (93,431
                            )Financing
      ActivitiesNet
      change in deposits
                            
                            
                            29,470
                            
                            
                            
                            45,578Change
      in short-term borrowings
                            
                            
                            (905
                            )
                            
                            
                            19,731Repayments
      to Federal Home Loan Bank
                            
                            
                            (149
                            )
                            
                            
                            (138
                            )Issuance
      of preferred stock, net
                            
                            
                            -
                            
                            
                            
                            20,000Issuance
      of common stock under dividend reinvestment program
                            
                            
                            13
                            
                            
                            
                            2Issuance
      of common stock for stock options exercised
                            
                            
                            -
                            
                            
                            
                            50Issuance
      of common stock for employee benefit plans
                            
                            
                            63
                            
                            
                            
                            239Dividends
      paid on common stock
                            
                            
                            -
                            
                            
                            
                            (1,781
                            )Dividends
      paid on preferred stock
                            
                            
                            (500
                            )
                            
                            
                            (480
                            )Net
      cash from financing activities
                            
                            
                            27,992
                            
                            
                            
                            83,201(Decrease)
      Increase in cash and cash equivalents
                            
                            
                            (23,788
                            )
                            
                            
                            (869
                            )Cash
      and cash equivalents, beginning of period
                            
                            
                            98,533
                            
                            
                            
                            20,905Cash
      and cash equivalents, end of period
                            
                            $
                            74,745
                            
                            
                            $
                            20,036Supplemental noncash
      disclosures:Transfers from laons to real estate
      owned
                            
                            $
                            8,076
                            
                            
                            $
                            5,811





See
notes to the unaudited consolidated financial statements.


8





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





1.
            BASIS
      OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING
    POLICIES





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





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





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





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





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





The
Financial Accounting Standards Board issued new accounting guidance under
Accounting Standards Update (ASU) No. 2010-06 that requires new disclosures and
clarifies existing disclosure requirements about fair value measurement as set
forth in ASC Subtopic 820-10. The objective of the new guidance is to improve
these disclosures and increase transparency in financial reporting.
Specifically, the new guidance requires:





A
reporting entity to disclose separately the amounts of significant transfers in
and out of Level 1 and Level 2 fair value  measurements and describe
the reasons for the transfers; and





In the
reconciliation for fair value measurements using significant unobservable
inputs, a reporting entity should present separately information about
purchases, sales, issuances, and settlements.





9




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





1.
            BASIS
      OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES –
    (Continued)





In
addition, the guidance clarifies the requirements of the following existing
disclosures:





For
purposes of reporting fair value measurement for each class of assets and
liabilities, a reporting  entity needs to use judgment in determining
the appropriate classes of assets and  liabilities; and





A
reporting entity should provide disclosures about the valuation techniques and
inputs used to measure  fair value for both recurring and nonrecurring
fair value measurements.





ASU
2010-06 is effective for interim and annual reporting periods beginning after
December 15, 2009,  except for the disclosures about purchases, sales,
issuances, and settlements in the roll forward of  activity in Level 3
fair value measurements.  Those disclosures are effective for fiscal
years  beginning after December 15, 2010, and for interim periods
within those fiscal years. Early  application is
permitted.


10





2.
            SECURITIES





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





Gross
                      
                      
                      Gross(Dollars in thousands)
                      
                      Amortized
                      
                      
                      Unrealized
                      
                      
                      UnrealizedCost
                      
                      
                      Gains
                      
                      
                      Losses
                      
                      
                      Fair ValueSecurities
      available-for-sale:June
      30, 2010:U.S.
      Treasury and agencies
                      
                      $
                      80,864
                      
                      
                      $
                      507
                      
                      
                      $
                      -
                      
                      
                      $
                      81,371Government-sponsored
      mortgage-backed residential
                      
                      
                      40,784
                      
                      
                      
                      835
                      
                      
                      
                      -
                      
                      
                      
                      41,619Equity
                      
                      
                      433
                      
                      
                      
                      50
                      
                      
                      
                      (10
                      )
                      
                      
                      473State
      and municipal
                      
                      
                      20,643
                      
                      
                      
                      694
                      
                      
                      
                      (82
                      )
                      
                      
                      21,255Trust
      preferred securities
                      
                      
                      1,890
                      
                      
                      
                      -
                      
                      
                      
                      (1,847
                      )
                      
                      
                      43Total
                      
                      $
                      144,614
                      
                      
                      $
                      2,086
                      
                      
                      $
                      (1,939
                      )
                      
                      $
                      144,761December
      31, 2009:U.S.
      Treasury and agencies
                      
                      $
                      20,000
                      
                      
                      $
                      80
                      
                      
                      $
                      -
                      
                      
                      $
                      20,080Government-sponsored
      mortgage-backed residential
                      
                      
                      9,632
                      
                      
                      
                      171
                      
                      
                      
                      (51
                      )
                      
                      
                      9,752Equity
                      
                      
                      933
                      
                      
                      
                      60
                      
                      
                      
                      (3
                      )
                      
                      
                      990State
      and municipal
                      
                      
                      14,604
                      
                      
                      
                      399
                      
                      
                      
                      (110
                      )
                      
                      
                      14,893Trust
      preferred securities
                      
                      
                      1,983
                      
                      
                      
                      -
                      
                      
                      
                      (1,934
                      )
                      
                      
                      49Total
                      
                      $
                      47,152
                      
                      
                      $
                      710
                      
                      
                      $
                      (2,098
                      )
                      
                      $
                      45,764





Gross
                  
                  
                  GrossAmortized
                  
                  
                  Unrecognized
                  
                  
                  UnrecognizedCost
                  
                  
                  Gains
                  
                  
                  Losses
                  
                  
                  Fair ValueSecurities
      held-to-maturity:June
      30, 2010:Government-sponsored
      mortgage-backed residential
                  
                  $
                  112
                  
                  
                  $
                  3
                  
                  
                  $
                  -
                  
                  
                  $
                  115State
      and municipal
                  
                  
                  245
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  245Trust
      preferred securities
                  
                  
                  21
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  21Total
                  
                  $
                  378
                  
                  
                  $
                  3
                  
                  
                  $
                  -
                  
                  
                  $
                  381December
      31, 2009:Government-sponsored
      mortgage-backed residential
                  
                  $
                  902
                  
                  
                  $
                  6
                  
                  
                  $
                  -
                  
                  
                  $
                  908State
      and municipal
                  
                  
                  245
                  
                  
                  
                  3
                  
                  
                  
                  -
                  
                  
                  
                  248Trust
      preferred securities
                  
                  
                  20
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  20Total
                  
                  $
                  1,167
                  
                  
                  $
                  9
                  
                  
                  $
                  -
                  
                  
                  $
                  1,176


11


NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





2.
            SECURITIES
      – (Continued)





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





Available for Sale
                  
                  
                  Held-to-MaturityAmortized
                  
                  
                  Fair
                  
                  
                  Amortized
                  
                  
                  Fair(Dollars in thousands)
                  
                  Cost
                  
                  
                  Value
                  
                  
                  Cost
                  
                  
                  ValueDue
      in one year or less
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  245
                  
                  
                  $
                  245Due
      after one year through five years
                  
                  
                  20,515
                  
                  
                  
                  20,624
                  
                  
                  
                  -
                  
                  
                  
                  -Due
      after five years through ten years
                  
                  
                  41,404
                  
                  
                  
                  41,686
                  
                  
                  
                  -
                  
                  
                  
                  -Due
      after ten years
                  
                  
                  41,478
                  
                  
                  
                  40,359
                  
                  
                  
                  21
                  
                  
                  
                  21Government-sponsored
      mortgage-backed residential
                  
                  
                  40,784
                  
                  
                  
                  41,619
                  
                  
                  
                  112
                  
                  
                  
                  115Equity
                  
                  
                  433
                  
                  
                  
                  473
                  
                  
                  
                  -
                  
                  
                  
                  -$
                  144,614
                  
                  
                  $
                  144,761
                  
                  
                  $
                  378
                  
                  
                  $
                  381




For the
June 30, 2010 six month period, proceeds from sales of available-for-sale equity
securities were $500,000 and gross realized losses recognized in income were
$23,000.  There were not any sales of available-for-sale securities
for the June 30, 2009 period.





Investment
securities pledged to secure public deposits and FHLB advances had an amortized
cost of $29.2 million and fair value of $29.4 million at June 30, 2010 and a
$28.6 million amortized cost and fair value of $28.8 million at December 31,
2009.





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





June 30, 2010
                  
                  Less than 12 Months
                  
                  
                  12 Months or More
                  
                  
                  TotalFair
                  
                  
                  Unrealized
                  
                  
                  Fair
                  
                  
                  Unrealized
                  
                  
                  Fair
                  
                  
                  UnrealizedDescription of Securities
                  
                  Value
                  
                  
                  Loss
                  
                  
                  Value
                  
                  
                  Loss
                  
                  
                  Value
                  
                  
                  LossEquity
                  
                  $
                  75
                  
                  
                  $
                  (10
                  )
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  75
                  
                  
                  $
                  (10
                  )State
      and municipal
                  
                  
                  2,545
                  
                  
                  
                  (31
                  )
                  
                  
                  554
                  
                  
                  
                  (51
                  )
                  
                  
                  3,099
                  
                  
                  
                  (82
                  )Trust
      preferred securities
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  43
                  
                  
                  
                  (1,847
                  )
                  
                  
                  43
                  
                  
                  
                  (1,847
                  )Total
      temporarily impaired
                  
                  $
                  2,620
                  
                  
                  $
                  (41
                  )
                  
                  $
                  597
                  
                  
                  $
                  (1,898
                  )
                  
                  $
                  3,217
                  
                  
                  $
                  (1,939
                  )





December 31, 2009
                  
                  Less than 12 Months
                  
                  
                  12 Months or More
                  
                  
                  TotalFair
                  
                  
                  Unrealized
                  
                  
                  Fair
                  
                  
                  Unrealized
                  
                  
                  Fair
                  
                  
                  UnrealizedDescription of Securities
                  
                  Value
                  
                  
                  Loss
                  
                  
                  Value
                  
                  
                  Loss
                  
                  
                  Value
                  
                  
                  LossGovernment-sponsored
      mortgage-backed residential
                  
                  $
                  5,141
                  
                  
                  $
                  (51
                  )
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  5,141
                  
                  
                  $
                  (51
                  )Equity
                  
                  
                  75
                  
                  
                  
                  (3
                  )
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  75
                  
                  
                  
                  (3
                  )State
      and municipal
                  
                  
                  1,161
                  
                  
                  
                  (22
                  )
                  
                  
                  2,456
                  
                  
                  
                  (88
                  )
                  
                  
                  3,617
                  
                  
                  
                  (110
                  )Trust
      preferred securities
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  49
                  
                  
                  
                  (1,934
                  )
                  
                  
                  49
                  
                  
                  
                  (1,934
                  )Total
      temporarily impaired
                  
                  $
                  6,377
                  
                  
                  $
                  (76
                  )
                  
                  $
                  2,505
                  
                  
                  $
                  (2,022
                  )
                  
                  $
                  8,882
                  
                  
                  $
                  (2,098
                  )


12





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





2.
            SECURITIES
      – (Continued)





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





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





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





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





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





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





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


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


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


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


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


13


NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





2.
            SECURITIES
      – (Continued)





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





·
            Valuation
      estimates provided by our investment
broker;


·
            The
      amount of fair value decline;


·
            How
      long the decline in fair value has
existed;


·
            Significant
      rating agency changes on the
issuer;


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


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


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


·
            Other
      relevant observable inputs.





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





Moody's
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        % of CurrentCredit
                        
                        Current
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        Current
                        
                        
                        Deferrals and(Dollars in thousands)
                        
                        
                        
                        Ratings
                        
                        Moody's
                        
                        
                        
                        
                        
                        
                        
                        Estimated
                        
                        
                        Deferrals
                        
                        
                        DefaultsWhen
                        
                        Credit
                        
                        Par
                        
                        
                        Book
                        
                        
                        Fair
                        
                        
                        and
                        
                        
                        to Current
                        
                        
                        OTTISecurity
                        
                        Tranche
                        
                        Purchased
                        
                        Ratings
                        
                        Value
                        
                        
                        Value
                        
                        
                        Value
                        
                        
                        Defaults
                        
                        
                        Collateral
                        
                        
                        RecognizedPreferred
      Term Securities IV
                        
                        Mezzanine
                        
                        
                        A3
                        
                        Ca
                        
                        $
                        244
                        
                        
                        $
                        199
                        
                        
                        $
                        20
                        
                        
                        $
                        18,000
                        
                        
                        
                        27
                        %
                        
                        $
                        -Preferred
      Term Securities VI
                        
                        Mezzanine
                        
                        
                        A1
                        
                        Caa1
                        
                        
                        259
                        
                        
                        
                        21
                        
                        
                        
                        21
                        
                        
                        
                        33,000
                        
                        
                        
                        81
                        %
                        
                        
                        49Preferred
      Term Securities XV B1
                        
                        Mezzanine
                        
                        
                        A2
                        
                        Ca
                        
                        
                        1,004
                        
                        
                        
                        782
                        
                        
                        
                        14
                        
                        
                        
                        159,050
                        
                        
                        
                        27
                        %
                        
                        
                        45Preferred
      Term Securities XXI C2
                        
                        Mezzanine
                        
                        
                        A3
                        
                        Ca
                        
                        
                        1,018
                        
                        
                        
                        614
                        
                        
                        
                        6
                        
                        
                        
                        198,000
                        
                        
                        
                        26
                        %
                        
                        
                        -Preferred
      Term Securities XXII C1
                        
                        Mezzanine
                        
                        
                        A3
                        
                        Ca
                        
                        
                        503
                        
                        
                        
                        305
                        
                        
                        
                        3
                        
                        
                        
                        395,500
                        
                        
                        
                        29
                        %
                        
                        
                        89Total
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        3,028
                        
                        
                        $
                        1,921
                        
                        
                        $
                        64
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        
                        $
                        183





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





(Dollars in thousands)Beginning
      balance January 1, 2010
                    
                    $
                    862Increases
      to the amount related to the credit loss for which other-than-temporary
      impairment was previously recognized
                    
                    
                    183Ending
      balance June 30, 2010
                    
                    $
                    1,045


14


NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





3.
            LOANS





Loans are
summarized as follows:





June 30,
                    
                    
                    December 31,(Dollars in thousands)
                    
                    2010
                    
                    
                    2009Commercial
                    
                    $
                    53,470
                    
                    
                    $
                    62,940Real
      estate commercial
                    
                    
                    591,556
                    
                    
                    
                    627,788Real
      estate construction
                    
                    
                    12,982
                    
                    
                    
                    14,567Residential
      mortgage
                    
                    
                    174,306
                    
                    
                    
                    178,985Consumer
      and home equity
                    
                    
                    75,818
                    
                    
                    
                    74,844Indirect
      consumer
                    
                    
                    33,087
                    
                    
                    
                    36,628Loans
      held for sale
                    
                    
                    14,997
                    
                    
                    
                    8,183956,216
                    
                    
                    
                    1,003,935Less:Net
      deferred loan origination fees
                    
                    
                    (588
                    )
                    
                    
                    (826
                    )Allowance
      for loan losses
                    
                    
                    (20,953
                    )
                    
                    
                    (17,719
                    )(21,541
                    )
                    
                    
                    (18,545
                    )Loans
      Receivable
                    
                    $
                    934,675
                    
                    
                    $
                    985,390





The
allowance for loan loss is summarized as follows:





Three
      Months Ended
                        
                        
                        Six
      Months EndedJune
      30,
                        
                        
                        June
      30,(Dollars
      in thousands)
                        
                        2010
                        
                        
                        2009
                        
                        
                        2010
                        
                        
                        2009Balance,
      beginning of period
                        
                        $
                        18,810
                        
                        
                        $
                        15,072
                        
                        
                        $
                        17,719
                        
                        
                        $
                        13,565Provision
      for loan losses
                        
                        
                        3,274
                        
                        
                        
                        1,913
                        
                        
                        
                        5,026
                        
                        
                        
                        3,958Charge-offs
                        
                        
                        (1,193
                        )
                        
                        
                        (2,813
                        )
                        
                        
                        (1,904
                        )
                        
                        
                        (3,406
                        )Recoveries
                        
                        
                        62
                        
                        
                        
                        64
                        
                        
                        
                        112
                        
                        
                        
                        119Balance,
      end of period
                        
                        $
                        20,953
                        
                        
                        $
                        14,236
                        
                        
                        $
                        20,953
                        
                        
                        $
                        14,236





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





As of the
                  
                  
                  As of theSix Months Ended
                  
                  
                  Year EndedJune 30,
                  
                  
                  December 31,(Dollars in thousands)
                  
                  2010
                  
                  
                  2009End
      of period impaired loans
                  
                  $
                  37,028
                  
                  
                  $
                  37,998Amount
      of allowance for loan loss allocated
                  
                  
                  7,095
                  
                  
                  
                  4,111





15


NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





3.
            LOANS
      –
      (Continued)





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





June 30,
                  
                  
                  December 31,(Dollars in thousands)
                  
                  2010
                  
                  
                  2009Restructured
                  
                  $
                  1,321
                  
                  
                  $
                  9,812Loans
      past due over 90 days still on accrual
                  
                  
                  -
                  
                  
                  
                  -Non
      accrual loans
                  
                  
                  35,707
                  
                  
                  
                  28,186Total
                  
                  $
                  37,028
                  
                  
                  $
                  37,998





We have
allocated $255,000 of specific reserves to customers whose loan terms have been
modified in troubled debt restructurings as of June 30, 2010.  We are
not committed to lend additional funds to debtors whose loans have been modified
in a troubled debt restructuring.





4.
            EARNINGS
      (LOSS) PER SHARE





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





Three Months Ended
                    
                    
                    Six Months Ended(Dollars in thousands,
                    
                    June 30,
                    
                    
                    June 30,except per share data)
                    
                    2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Basic:Net
      income/(loss)
                    
                    $
                    (62
                    )
                    
                    $
                    715
                    
                    
                    $
                    693
                    
                    
                    $
                    1,476Less:Preferred
      stock dividends
                    
                    
                    (250
                    )
                    
                    
                    (213
                    )
                    
                    
                    (500
                    )
                    
                    
                    (480
                    )Accretion
      on preferred stock discount
                    
                    
                    (13
                    )
                    
                    
                    (14
                    )
                    
                    
                    (27
                    )
                    
                    
                    (25
                    )Net
      income/(loss) available to common shareholders
                    
                    $
                    (325
                    )
                    
                    $
                    488
                    
                    
                    $
                    166
                    
                    
                    $
                    971Weighted
      average common shares
                    
                    
                    4,718
                    
                    
                    
                    4,688
                    
                    
                    
                    4,717
                    
                    
                    
                    4,683Diluted:Weighted
      average common shares
                    
                    
                    4,718
                    
                    
                    
                    4,688
                    
                    
                    
                    4,717
                    
                    
                    
                    4,683Dilutive
      effect of stock options and warrants
                    
                    
                    -
                    
                    
                    
                    38
                    
                    
                    
                    -
                    
                    
                    
                    3Weighted
      average common and incremental shares
                    
                    
                    4,718
                    
                    
                    
                    4,726
                    
                    
                    
                    4,717
                    
                    
                    
                    4,686Earnings/(Loss)
      Per Common Share:Basic
                    
                    $
                    (0.07
                    )
                    
                    $
                    0.10
                    
                    
                    $
                    0.04
                    
                    
                    $
                    0.21Diluted
                    
                    $
                    (0.07
                    )
                    
                    $
                    0.10
                    
                    
                    $
                    0.04
                    
                    
                    $
                    0.21





Stock
options for 237,949 shares of common stock were not included in the June 30,
2010 computation of diluted earnings per share for the quarter and year to date
because their impact was anti-dilutive.  Stock options for 127,590 and
157,805 shares of common stock were not included in the June 30, 2009
computation of diluted earnings per share for the quarter and year to date
because their impact was anti-dilutive. Warrants to purchase 215,983 shares at
June 30, 2010 and 2009 were not included in the quarter and year to date
computation because their impact was anti-dilutive.





5.           STOCK
OPTION PLAN





Our 2006
Stock Incentive Plan, which is shareholder approved, succeeded our 1998 Stock
Option and Incentive Plan. Under the 2006 Plan, we may grant either incentive or
non-qualified stock options tokey employees and
directorsfor a
total of 647,350 shares of our common stock at not less than fair value at the
date such options are granted.Options available for
future grant under the 1998 Plan totaled 38,500 shares
and were rolled into the 2006 Plan.We believe that the
ability to award stock options and other forms of stock-based incentive
compensation can assist us in attracting and retaining key employees.
Stock-based incentive compensation is also a means to align the interests of key
employees with those of our shareholders by providing awards intended to reward
 recipients for our long-term growth.The option to purchase
shares vest over periods of one to five years and expire ten years after the
date of grant.We
issue new shares of common stock upon the exercise of stock options. At June 30,
2010 options available for future grant under the 2006 Plan totaled
494,750.Compensation cost
related to options granted under the 1998 and 2006 Plans that was charged
against earnings for the six month periods ended June 30, 2010and 2009 was $47,000 and
$52,000.


16





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





5.
            STOCK
      OPTION PLAN–
      (Continued)





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





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





WeightedWeighted
                  
                  
                  AverageNumber
                  
                  
                  Average
                  
                  
                  Remaining
                  
                  
                  Aggregateof
                  
                  
                  Exercise
                  
                  
                  Contractual
                  
                  
                  IntrinsicOptions
                  
                  
                  Price
                  
                  
                  Term
                  
                  
                  Value(Dollars
      In Thousands)Outstanding,
      beginning of period
                  
                  
                  279,706
                  
                  
                  $
                  15.12Granted
      during period
                  
                  
                  -
                  
                  
                  
                  -Forfeited
      during period
                  
                  
                  (1,757
                  )
                  
                  
                  11.61Exercised
      during period
                  
                  
                  -
                  
                  
                  
                  -Cancelled
      during period
                  
                  
                  (40,000
                  )
                  
                  
                  9.06Outstanding,
      end of period
                  
                  
                  237,949
                  
                  
                  $
                  16.17
                  
                  
                  
                  7.0
                  
                  
                  $
                  -Eligible
      for exercise at period end
                  
                  
                  103,141
                  
                  
                  $
                  20.16
                  
                  
                  
                  4.7
                  
                  
                  $
                  -





There
were no options exercised, modified or settled in cash for the period ended June
30, 2010.  The total intrinsic value of options exercised during the
period ended June 30, 2009 was $116,000.  There was no tax benefit
recognized from the option exercises as they are considered incentive stock
options.  Management expects all outstanding unvested options will
vest.





As of
June 30, 2010 there was $221,000 of total unrecognized compensation cost related
to non-vested share-based compensation arrangements granted under the 1998 and
2006 Plans.  That cost is expected to be recognized over a
weighted-average period of 3.1 years.  Cash received from option
exercises under all share-based payment arrangements for the periods ended June
30, 2010 and 2009 was $0 and $50,000.





6.
            FAIR
      VALUE





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





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


17


NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





6.
            FAIR
      VALUE –
      (Continued)





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





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





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





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





Assets and Liabilities
Measured at Fair Value on a Recurring Basis





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





Quoted Prices in
                    Active Markets for
                  
                  
                  Significant Other
                  
                  
                  SignificantJune 30,
                  
                  
                  Identical Assets
                  
                  
                  Observable Inputs
                  
                  
                  Unobservable Inputs(Dollars in thousands)
                  
                  2010
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Assets:U.S.
      Treasury and agencies
                  
                  $
                  81,371
                  
                  
                  $
                  -
                  
                  
                  $
                  81,371
                  
                  
                  $
                  -Government-sponsored
      mortgage-backed residential
                  
                  
                  41,619
                  
                  
                  
                  -
                  
                  
                  
                  41,619
                  
                  
                  
                  -Equity
                  
                  
                  473
                  
                  
                  
                  182
                  
                  
                  
                  -
                  
                  
                  
                  291State
      and municipal
                  
                  
                  21,255
                  
                  
                  
                  -
                  
                  
                  
                  21,255
                  
                  
                  
                  -Trust
      preferred securities
                  
                  
                  43
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  43Total
                  
                  $
                  144,761
                  
                  
                  $
                  182
                  
                  
                  $
                  144,245
                  
                  
                  $
                  334





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





18




NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





6.
            FAIR
      VALUE - (Continued)





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





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





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





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





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





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


19





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





6.
            FAIR
      VALUE - (Continued)





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





Fair Value MeasurementsUsing SignificantUnobservable Inputs(Level 3)Three Months Ended
                                            
                                            
                                            Six Months EndedJune 30,
                                            
                                            
                                            June 30,(Dollars in thousands)
                                            
                                            2010
                                            
                                            
                                            2009
                                            
                                            
                                            2010
                                            
                                            
                                            2009Beginning
      balance
                                            
                                            $
                                            335
                                            
                                            
                                            $
                                            330
                                            
                                            
                                            $
                                            340
                                            
                                            
                                            $
                                            364Total
      gains or losses:Impairment
      charges on securities
                                            
                                            
                                            (11
                                            )
                                            
                                            
                                            (236
                                            )
                                            
                                            
                                            (134
                                            )
                                            
                                            
                                            (376
                                            )Included
      in other comprehensive income
                                            
                                            
                                            10
                                            
                                            
                                            
                                            445
                                            
                                            
                                            
                                            128
                                            
                                            
                                            
                                            551Transfers
      in and/or out of Level 3
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -
                                            
                                            
                                            
                                            -Ending
      balance
                                            
                                            $
                                            334
                                            
                                            
                                            $
                                            539
                                            
                                            
                                            $
                                            334
                                            
                                            
                                            $
                                            539





Assets and Liabilities
Measured at Fair Value on a Nonrecurring Basis





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





Quoted Prices inActive Markets for
                  
                  
                  Significant Other
                  
                  
                  SignificantJune 30,
                  
                  
                  Identical Assets
                  
                  
                  Observable Inputs
                  
                  
                  Unobservable Inputs(Dollars in thousands)
                  
                  2010
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Assets:Impaired
      loans
                  
                  $
                  29,933
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  29,933Real
      estate acquired through foreclosure
                  
                  
                  14,703
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  14,703Trust
      preferred security held-to-maturity
                  
                  
                  21
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  21





Quoted Prices inActive Markets for
                  
                  
                  Significant Other
                  
                  
                  SignificantDecember 31,
                  
                  
                  Identical Assets
                  
                  
                  Observable Inputs
                  
                  
                  Unobservable Inputs(Dollars in thousands)
                  
                  2009
                  
                  
                  (Level 1)
                  
                  
                  (Level 2)
                  
                  
                  (Level 3)Assets:Impaired
      loans
                  
                  $
                  33,887
                  
                  
                  $
                  -
                  
                  
                  $
                  -
                  
                  
                  $
                  33,887Real
      estate acquiredthrough foreclosure
                  
                  
                  8,428
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  8,428Trust
      preferred securityheld-to-maturity
                  
                  
                  20
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  20





Impaired
loans, which are measured for impairment using the fair value of the collateral
for collateral dependent loans, had a carrying amount of $37.0 million, with a
valuation allowance of $7.1 million, resulting in an additional provision for
loan losses of $3.5 million and $4.8 million for the three and six month periods
ended June 30, 2010.  Values for collateral dependent loans are
generally based on appraisals obtained from licensed real estate appraisals and
in certain circumstances consideration of offers obtained to purchase properties
prior to foreclosure.  Appraisals for commercial real estate generally
use three methods to derive value: cost, sales or market comparison and income
approach.  The cost method bases value on the estimated cost to
replace the current property after considering adjustments for
depreciation.  Values of the market comparison approach evaluate the
sales price of similar properties in the same market area.  The income
approach considers net operating income generated by the property and an
investors required return.  The final value is a reconciliation of
these three approaches and takes into consideration any other factors management
deems relevant to arrive at a representative fair value.


20


NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





6.
            FAIR
      VALUE - (Continued)





Real
estate owned acquired through foreclosure is recorded at fair value less
estimated selling costs at the date of foreclosure.  Fair value is
based on the appraised market value of the property based on sales of similar
assets.  The fair value may be subsequently reduced if the estimated
fair value declines below the original appraised value.  Fair value
adjustments of $388,000 were made to real estate owned during the three and six
month periods ended June 30, 2010.





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





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





Fair Value of Financial
Instruments







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




(Dollars in thousands)
                  
                  June 30, 2010
                  
                  
                  December 31, 2009Carrying
                  
                  
                  Fair
                  
                  
                  Carrying
                  
                  
                  FairValue
                  
                  
                  Value
                  
                  
                  Value
                  
                  
                  ValueFinancial assets:Cash
      and due from banks
                  
                  $
                  74,745
                  
                  
                  $
                  74,745
                  
                  
                  $
                  98,533
                  
                  
                  $
                  98,533Securities
      held-to-maturity
                  
                  
                  357
                  
                  
                  
                  360
                  
                  
                  
                  1,147
                  
                  
                  
                  1,156Loans
      held for sale
                  
                  
                  14,997
                  
                  
                  
                  15,216
                  
                  
                  
                  8,183
                  
                  
                  
                  8,257Loans,
      net
                  
                  
                  920,649
                  
                  
                  
                  919,725
                  
                  
                  
                  977,207
                  
                  
                  
                  982,584Accrued
      interest receivable
                  
                  
                  5,907
                  
                  
                  
                  5,907
                  
                  
                  
                  5,658
                  
                  
                  
                  5,658FHLB
      stock
                  
                  
                  8,515
                  
                  
                  
                  N/A
                  
                  
                  
                  8,515
                  
                  
                  
                  N/AFinancial
      liabilities:Deposits
                  
                  
                  1,079,285
                  
                  
                  
                  1,069,660
                  
                  
                  
                  1,049,815
                  
                  
                  
                  1,042,957Short-term
      borrowings
                  
                  
                  595
                  
                  
                  
                  595
                  
                  
                  
                  1,500
                  
                  
                  
                  1,500Advances
      from Federal Home Loan Bank
                  
                  
                  52,596
                  
                  
                  
                  53,392
                  
                  
                  
                  52,745
                  
                  
                  
                  55,856Subordinated
      debentures
                  
                  
                  18,000
                  
                  
                  
                  12,743
                  
                  
                  
                  18,000
                  
                  
                  
                  12,743Accrued
      interest payable
                  
                  
                  289
                  
                  
                  
                  289
                  
                  
                  
                  360
                  
                  
                  
                  360





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





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


21





NOTES
TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS





7.
            PREFERRED
      STOCK





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





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





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





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





8.
            REGULATORY
      MATTERS





The Bank
currently has a regulatory agreement with the FDIC that requires us to obtain
the consent of the Regional Director of the FDIC and the Commissioner of the
KDFI to declare and pay cash dividends.  We also have a regulatory
agreement with the FDIC that requires us to maintain a Tier 1 leverage ratio of
8%.  We are currently in compliance with the Tier 1 capital
requirement. The Corporation has entered into an agreement with the Federal
Reserve.  Under this agreement, we must obtain regulatory approval
before declaring any dividends.  We may not redeem shares or obtain
additional borrowings without prior approval.


22





Item 2.




MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION


AND
RESULTS OF OPERATIONS





GENERAL





We
operate 22 full-service banking centers and a commercial private banking center
in eight contiguous counties in central Kentucky along the Interstate 65
corridor and within the Louisville metropolitan area, including southern
Indiana.  Our markets range from Louisville in Jefferson County,
Kentucky approximately 40 miles north of our headquarters in Elizabethtown,
Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown
to Harrison County, Indiana approximately 60 miles northwest of our
headquarters.  Our markets are supported by a diversified industry
base and have a regional population of over 1 million.  Louisville and
Jefferson County comprise the 29th largest
city in the United States.  We operate in Hardin, Nelson, Hart,
Bullitt, Meade and Jefferson counties in Kentucky and in Harrison and Floyd
counties in southern Indiana.





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





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





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





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





OVERVIEW





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





Our
retail branch network continues to generate encouraging
results.  Total deposits have grown 57% over the past three years.
Total deposits were $1.08 billion at June 30, 2010, an increase of $29.5 million
or 3% from December 31, 2009.  After our acquisition of Farmers State
Bank in 2008, our retail branch network in the Louisville market has broadened
to sixteen offices.  In May 2009, we opened the Fort Knox banking
center, our twenty-first banking center, which expanded our current footprint in
Hardin County, Kentucky.  The Fort Knox banking center complements our
existing branch located in Radcliff, Kentucky and is located just outside the
main entrance to the Fort Knox military base.   We also completed
the construction of our twenty-second banking center which opened in July 2009.
The branch is located in the Middletown area of Louisville,
Kentucky.  Competition for deposits continues to be challenging in all
of the markets we serve. We believe this intense competition combined with
continued re-pricing of variable rate loans could add to additional margin
compression.


23





We have
developed a strong commercial real estate niche in our markets.  We
have an experienced team of bankers who focus on providing service and
convenience to our customers.  It is quite common for our bankers to
close loans at a customer’s place of business or even the customer’s personal
residence.   This high level of service has been well received in
our Louisville market, which is dominated by regional banks.  To
further develop our commercial banking relationships in Louisville, we opened a
private banking office in 2007.  This upscale facility complements our
full service centers in Louisville by attracting commercial deposit
relationships in conjunction with our commercial lending
relationships.





Despite
the continued adverse economic conditions during the first half of 2010, the
Corporation’s capital position remained well-capitalized as defined by
regulatory standards.  Our capital position was further bolstered in
the first quarter of 2009 by our participation in the U.S. Treasury Department
Capital Purchase Program (“CPP”).  Under the CPP, we sold $20 million
of cumulative perpetual preferred shares to the U.S. Treasury in a transaction
that closed on January 9, 2009.





We believe that the current adverse
economic conditions will be long lasting.  During the last quarter of
2008, the continued economic slowdown moved to sectors not previously impacted,
including consumer, commercial, industrial among others.  Credit
issues are broadening in these sectors and economic recovery is most likely
several quarters away.  We will continue to monitor credit quality
very closely in 2010 as this adverse economic climate persists.  As
the economy and the financial sector continue to struggle, probable losses in
the loan portfolio could increase, resulting in higher provision for loan losses
during 2010.





CRITICAL
ACCOUNTING POLICIES





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





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





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





Based on
our calculation, an allowance of $21.0 millionor 2.23% of total loans
was our estimate of probable losses within the loan portfolio as ofJune 30, 2010.This estimate required
a provision for loan losses on the income statement of$5.0 million for the
2010 six month period.If the mix and amount of future charge off percentages differ
significantly from those assumptions used by management in making its
determination, the allowance for loan losses and provision for loan losses on
the income statement could materially increase.





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


24


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





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





RESULTS
OF OPERATIONS





Net loss
for the quarter ended June 30, 2010 was $(62,000) or $(0.07) per common share
compared to net income of $715,000 or $0.10 per common share diluted for the
same period in 2009. Net income for the six
month period ended June 30, 2010 was $693,000 or $.04 per common share diluted
compared to $1.5 million or $.21 per common share diluted for the same period a
year ago.  Earnings decreased for 2010 compared to 2009 due to a
decrease in our net interest margin, an increase in provision for loan loss
expense, write downs taken on real estate acquired through foreclosure, and a
higher level of non-interest expense. Net income available to common
shareholders was also impacted by dividends paid on preferred shares. Our book value per
common share decreased from $15.60 at June 30, 2009 to $14.14 at June 30,
2010.Annualized
net income for the first six months of 2010 represented a return on average
assets of .11% and a return on average equity of 1.62%.These compare with a
return on average assets of .18% and a return on average equity of 2.12% for the
first six months of 2009 also annualized.





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





The
increase in the volume of interest earning assets and the change in the mix of
interest earning assets had a moderate impact on net interest income, which
increased $263,000 and $275,000 for the three and six month 2010 periods
compared to the same prior year periods.  Average interest earning
assets increased $185.4 million for the 2010 quarter and $189.7 million for the
six months compared to 2009.  Despite the increase in interest earning
assets, our net interest margin realized a sharp decline.  The decline
is primarily attributed to our efforts to increase liquidity by placing assets
into lower yielding investments other than loans.  The yield on
earning assets averaged 5.19% and 5.17% for the three and six month 2010 periods
compared to an average yield on earning assets of 5.82% and 5.91% for the same
periods in 2009.  This decrease was offset by a decrease in our cost
of funds.  Net interest margin as a percent of average earning assets
decreased47 basis
points to 3.23% for the quarter ended June 30, 2010 and 53 basis points to 3.18%
for the six months ended June 30, 2010 compared to 3.70% and 3.71% for the same
periods in 2009.





Our cost
of funds averaged 2.12% and 2.15% for the quarter and six month periods of 2010
compared to an average cost of funds of 2.31% and 2.40% for the same period in
2009. Going forward, our cost of funds is expected to continue to decrease as
certificates of deposit re-price and roll off into new certificates of deposit
at lower interest rates.





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


25


AVERAGE
BALANCE SHEET





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





Quarter Ended June 30,2010
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      2009(Dollars
      in thousands)
                                                                      
                                                                      Average
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      Average
                                                                      
                                                                      
                                                                      Average
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      AverageBalance
                                                                      
                                                                      
                                                                      Interest
                                                                      
                                                                      
                                                                      Yield/Cost (5)
                                                                      
                                                                      
                                                                      Balance
                                                                      
                                                                      
                                                                      Interest
                                                                      
                                                                      
                                                                      Yield/Cost (5)ASSETSInterest
      earning assets:U.S.
      Treasury and agencies
                                                                      
                                                                      $
                                                                      61,371
                                                                      
                                                                      
                                                                      $
                                                                      452
                                                                      
                                                                      
                                                                      
                                                                      2.95
                                                                      %
                                                                      
                                                                      $
                                                                      8,930
                                                                      
                                                                      
                                                                      $
                                                                      63
                                                                      
                                                                      
                                                                      
                                                                      2.83
                                                                      %Mortgage-backed
      securities
                                                                      
                                                                      
                                                                      24,785
                                                                      
                                                                      
                                                                      
                                                                      253
                                                                      
                                                                      
                                                                      
                                                                      4.09
                                                                      
                                                                      
                                                                      
                                                                      7,109
                                                                      
                                                                      
                                                                      
                                                                      74
                                                                      
                                                                      
                                                                      
                                                                      4.17Equity
      securities
                                                                      
                                                                      
                                                                      500
                                                                      
                                                                      
                                                                      
                                                                      10
                                                                      
                                                                      
                                                                      
                                                                      8.02
                                                                      
                                                                      
                                                                      
                                                                      942
                                                                      
                                                                      
                                                                      
                                                                      24
                                                                      
                                                                      
                                                                      
                                                                      10.22State and political subdivision securities (1)
                                                                      
                                                                      
                                                                      19,057
                                                                      
                                                                      
                                                                      
                                                                      306
                                                                      
                                                                      
                                                                      
                                                                      6.44
                                                                      
                                                                      
                                                                      
                                                                      11,210
                                                                      
                                                                      
                                                                      
                                                                      178
                                                                      
                                                                      
                                                                      
                                                                      6.37Corporate
      bonds
                                                                      
                                                                      
                                                                      1,970
                                                                      
                                                                      
                                                                      
                                                                      22
                                                                      
                                                                      
                                                                      
                                                                      4.48
                                                                      
                                                                      
                                                                      
                                                                      2,873
                                                                      
                                                                      
                                                                      
                                                                      26
                                                                      
                                                                      
                                                                      
                                                                      3.63Loans
      (2) (3)
      (4)
                                                                      
                                                                      
                                                                      964,428
                                                                      
                                                                      
                                                                      
                                                                      14,267
                                                                      
                                                                      
                                                                      
                                                                      5.93
                                                                      
                                                                      
                                                                      
                                                                      967,067
                                                                      
                                                                      
                                                                      
                                                                      14,155
                                                                      
                                                                      
                                                                      
                                                                      5.87FHLB
      stock
                                                                      
                                                                      
                                                                      8,515
                                                                      
                                                                      
                                                                      
                                                                      90
                                                                      
                                                                      
                                                                      
                                                                      4.24
                                                                      
                                                                      
                                                                      
                                                                      8,515
                                                                      
                                                                      
                                                                      
                                                                      91
                                                                      
                                                                      
                                                                      
                                                                      4.29Interest
      bearing deposits
                                                                      
                                                                      
                                                                      114,036
                                                                      
                                                                      
                                                                      
                                                                      50
                                                                      
                                                                      
                                                                      
                                                                      0.18
                                                                      
                                                                      
                                                                      
                                                                      2,584
                                                                      
                                                                      
                                                                      
                                                                      27
                                                                      
                                                                      
                                                                      
                                                                      4.19Total
      interest earning assets
                                                                      
                                                                      
                                                                      1,194,662
                                                                      
                                                                      
                                                                      
                                                                      15,450
                                                                      
                                                                      
                                                                      
                                                                      5.19
                                                                      
                                                                      
                                                                      
                                                                      1,009,230
                                                                      
                                                                      
                                                                      
                                                                      14,638
                                                                      
                                                                      
                                                                      
                                                                      5.82Less:  Allowance
      for loan losses
                                                                      
                                                                      
                                                                      (18,703
                                                                      )
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      (14,850
                                                                      )Non-interest
      earning assets
                                                                      
                                                                      
                                                                      85,040
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      86,652Total
      assets
                                                                      
                                                                      $
                                                                      1,260,999
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      $
                                                                      1,081,032LIABILITIES
      AND STOCKHOLDERS' EQUITYInterest
      bearing liabilities:Savings
      accounts
                                                                      
                                                                      $
                                                                      117,309
                                                                      
                                                                      
                                                                      $
                                                                      227
                                                                      
                                                                      
                                                                      
                                                                      0.78
                                                                      %
                                                                      
                                                                      $
                                                                      118,938
                                                                      
                                                                      
                                                                      $
                                                                      201
                                                                      
                                                                      
                                                                      
                                                                      0.68
                                                                      %NOW
      and money market accounts
                                                                      
                                                                      
                                                                      261,968
                                                                      
                                                                      
                                                                      
                                                                      725
                                                                      
                                                                      
                                                                      
                                                                      1.11
                                                                      
                                                                      
                                                                      
                                                                      161,383
                                                                      
                                                                      
                                                                      
                                                                      260
                                                                      
                                                                      
                                                                      
                                                                      0.65Certificates
      of deposit and other time deposits
                                                                      
                                                                      
                                                                      651,933
                                                                      
                                                                      
                                                                      
                                                                      3,938
                                                                      
                                                                      
                                                                      
                                                                      2.42
                                                                      
                                                                      
                                                                      
                                                                      490,522
                                                                      
                                                                      
                                                                      
                                                                      3,885
                                                                      
                                                                      
                                                                      
                                                                      3.18Short
      term borrowings
                                                                      
                                                                      
                                                                      744
                                                                      
                                                                      
                                                                      
                                                                      11
                                                                      
                                                                      
                                                                      
                                                                      5.93
                                                                      
                                                                      
                                                                      
                                                                      83,421
                                                                      
                                                                      
                                                                      
                                                                      47
                                                                      
                                                                      
                                                                      
                                                                      0.23FHLB
      advances
                                                                      
                                                                      
                                                                      52,607
                                                                      
                                                                      
                                                                      
                                                                      596
                                                                      
                                                                      
                                                                      
                                                                      4.54
                                                                      
                                                                      
                                                                      
                                                                      52,820
                                                                      
                                                                      
                                                                      
                                                                      600
                                                                      
                                                                      
                                                                      
                                                                      4.56Subordinated
      debentures
                                                                      
                                                                      
                                                                      18,000
                                                                      
                                                                      
                                                                      
                                                                      331
                                                                      
                                                                      
                                                                      
                                                                      7.38
                                                                      
                                                                      
                                                                      
                                                                      18,000
                                                                      
                                                                      
                                                                      
                                                                      329
                                                                      
                                                                      
                                                                      
                                                                      7.33Total
      interest bearing liabilities
                                                                      
                                                                      
                                                                      1,102,561
                                                                      
                                                                      
                                                                      
                                                                      5,828
                                                                      
                                                                      
                                                                      
                                                                      2.12
                                                                      
                                                                      
                                                                      
                                                                      925,084
                                                                      
                                                                      
                                                                      
                                                                      5,322
                                                                      
                                                                      
                                                                      
                                                                      2.31Non-interest
      bearing liabilities:Non-interest
      bearing deposits
                                                                      
                                                                      
                                                                      67,655
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      59,396Other
      liabilities
                                                                      
                                                                      
                                                                      3,945
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3,194Total
      liabilities
                                                                      
                                                                      
                                                                      1,174,161
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      987,674Stockholders'
      equity
                                                                      
                                                                      
                                                                      86,838
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      93,358Total
      liabilities and stockholders' equity
                                                                      
                                                                      $
                                                                      1,260,999
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      $
                                                                      1,081,032Net
      interest income
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      $
                                                                      9,622
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      $
                                                                      9,316Net
      interest spread
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3.07
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3.51
                                                                      %Net
      interest margin
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3.23
                                                                      %
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      
                                                                      3.70
                                                                      %





(1)Taxable equivalent yields
are calculated assuming a 34% federal income tax rate.


(2)Includes loan fees,
immaterial in amount, in both interest income and the calculation of yield on
loans.


(3)Calculations include
non-accruing loans in the average loan amounts outstanding.


(4)Includes loans held for
sale.


(5)Annualized


26




Six Months Ended June 30,2010
                
                
                
                
                
                
                
                
                2009(Dollars in thousands)
                
                Average
                
                
                
                
                
                Average
                
                
                Average
                
                
                
                
                
                AverageBalance
                
                
                Interest
                
                
                Yield/Cost (5)
                
                
                Balance
                
                
                Interest
                
                
                Yield/Cost (5)ASSETSInterest
      earning assets:U.S.
      Treasury and agencies
                
                $
                44,983
                
                
                $
                627
                
                
                
                2.81
                %
                
                $
                5,430
                
                
                $
                102
                
                
                
                3.79
                %Mortgage-backed
      securities
                
                
                19,544
                
                
                
                403
                
                
                
                4.16
                
                
                
                7,400
                
                
                
                156
                
                
                
                4.25Equity
      securities
                
                
                665
                
                
                
                35
                
                
                
                10.61
                
                
                
                941
                
                
                
                57
                
                
                
                12.22State
      and political subdivision securities (1)
                
                
                17,712
                
                
                
                565
                
                
                
                6.43
                
                
                
                10,152
                
                
                
                339
                
                
                
                6.73Corporate
      bonds
                
                
                1,932
                
                
                
                47
                
                
                
                4.91
                
                
                
                2,718
                
                
                
                60
                
                
                
                4.45Loans
      (2) (3)
      (4)
                
                
                976,537
                
                
                
                28,314
                
                
                
                5.85
                
                
                
                953,357
                
                
                
                28,099
                
                
                
                5.94FHLB
      stock
                
                
                8,515
                
                
                
                184
                
                
                
                4.36
                
                
                
                8,515
                
                
                
                187
                
                
                
                4.43Interest
      bearing deposits
                
                
                111,048
                
                
                
                75
                
                
                
                0.14
                
                
                
                2,770
                
                
                
                51
                
                
                
                3.71Total
      interest earning assets
                
                
                1,180,936
                
                
                
                30,250
                
                
                
                5.17
                
                
                
                991,283
                
                
                
                29,051
                
                
                
                5.91Less:  Allowance
      for loan losses
                
                
                (18,062
                )
                
                
                
                
                
                
                
                
                
                
                (14,322
                )Non-interest
      earning assets
                
                
                84,304
                
                
                
                
                
                
                
                
                
                
                
                83,421Total
      assets
                
                $
                1,247,178
                
                
                
                
                
                
                
                
                
                
                $
                1,060,382LIABILITIES
      AND STOCKHOLDERS' EQUITYInterest
      bearing liabilities:Savings
      accounts
                
                $
                121,935
                
                
                $
                466
                
                
                
                0.77
                %
                
                $
                115,043
                
                
                $
                398
                
                
                
                0.70
                %NOW
      and money market accounts
                
                
                257,697
                
                
                
                1,499
                
                
                
                1.17
                
                
                
                159,628
                
                
                
                509
                
                
                
                0.64Certificates
      of deposit and other time deposits
                
                
                638,750
                
                
                
                7,794
                
                
                
                2.46
                
                
                
                491,127
                
                
                
                7,939
                
                
                
                3.26Short
      term borrowings
                
                
                832
                
                
                
                32
                
                
                
                7.76
                
                
                
                71,681
                
                
                
                90
                
                
                
                0.25FHLB
      advances
                
                
                52,648
                
                
                
                1,189
                
                
                
                4.55
                
                
                
                52,712
                
                
                
                1,197
                
                
                
                4.58Subordinated
      debentures
                
                
                18,000
                
                
                
                658
                
                
                
                7.37
                
                
                
                18,000
                
                
                
                658
                
                
                
                7.37Total
      interest bearing liabilities
                
                
                1,089,862
                
                
                
                11,638
                
                
                
                2.15
                
                
                
                908,191
                
                
                
                10,791
                
                
                
                2.40Non-interest
      bearing liabilities:Non-interest
      bearing deposits
                
                
                66,866
                
                
                
                
                
                
                
                
                
                
                
                56,757Other
      liabilities
                
                
                3,961
                
                
                
                
                
                
                
                
                
                
                
                2,899Total
      liabilities
                
                
                1,160,689
                
                
                
                
                
                
                
                
                
                
                
                967,847Stockholders'
      equity
                
                
                86,489
                
                
                
                
                
                
                
                
                
                
                
                92,535Total
      liabilities and stockholders' equity
                
                $
                1,247,178
                
                
                
                
                
                
                
                
                
                
                $
                1,060,382Net
      interest income
                
                
                
                
                
                $
                18,612
                
                
                
                
                
                
                
                
                
                
                $
                18,260Net
      interest spread
                
                
                
                
                
                
                
                
                
                
                3.02
                %
                
                
                
                
                
                
                
                
                
                
                3.51
                %Net
      interest margin
                
                
                
                
                
                
                
                
                
                
                3.18
                %
                
                
                
                
                
                
                
                
                
                
                3.71
                %





(1)Taxable equivalent yields
are calculated assuming a 34% federal income tax rate.


(2)Includes loan fees,
immaterial in amount, in both interest income and the calculation of yield on
loans.


(3)Calculations include
non-accruing loans in the average loan amounts outstanding.


(4)Includes loans held for
sale.


(5)Annualized


27


RATE/VOLUME
ANALYSIS





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





Three Months Ended
                    
                    
                    Six Months EndedJune 30,
                    
                    
                    June 30,2010 vs. 2009
                    
                    
                    2010 vs. 2009Increase (decrease)
                    
                    
                    Increase (decrease)Due
      to change in
                    
                    
                    Due
      to change in(Dollars
      in thousands)
                    
                    
                    
                    
                    
                    
                    
                    Net
                    
                    
                    
                    
                    
                    
                    
                    
                    NetRate
                    
                    
                    Volume
                    
                    
                    Change
                    
                    
                    Rate
                    
                    
                    Volume
                    
                    
                    ChangeInterest
      income:U.S.
      Treasury and agencies
                    
                    $
                    3
                    
                    
                    $
                    386
                    
                    
                    $
                    389
                    
                    
                    $
                    (33
                    )
                    
                    $
                    558
                    
                    
                    $
                    525Mortgage-backed
      securities
                    
                    
                    (2
                    )
                    
                    
                    181
                    
                    
                    
                    179
                    
                    
                    
                    (3
                    )
                    
                    
                    250
                    
                    
                    
                    247Equity
      securities
                    
                    
                    (4
                    )
                    
                    
                    (10
                    )
                    
                    
                    (14
                    )
                    
                    
                    (7
                    )
                    
                    
                    (15
                    )
                    
                    
                    (22
                    )State
      and political subdivisionsecurities
                    
                    
                    2
                    
                    
                    
                    126
                    
                    
                    
                    128
                    
                    
                    
                    (16
                    )
                    
                    
                    242
                    
                    
                    
                    226Corporate
      bonds
                    
                    
                    5
                    
                    
                    
                    (9
                    )
                    
                    
                    (4
                    )
                    
                    
                    6
                    
                    
                    
                    (19
                    )
                    
                    
                    (13
                    )Loans
                    
                    
                    151
                    
                    
                    
                    (39
                    )
                    
                    
                    112
                    
                    
                    
                    (461
                    )
                    
                    
                    676
                    
                    
                    
                    215FHLB
      stock
                    
                    
                    (1
                    )
                    
                    
                    -
                    
                    
                    
                    (1
                    )
                    
                    
                    (3
                    )
                    
                    
                    -
                    
                    
                    
                    (3
                    )Interest
      bearing deposits
                    
                    
                    (50
                    )
                    
                    
                    73
                    
                    
                    
                    23
                    
                    
                    
                    (96
                    )
                    
                    
                    120
                    
                    
                    
                    24Total
      interest earning assets
                    
                    
                    104
                    
                    
                    
                    708
                    
                    
                    
                    812
                    
                    
                    
                    (613
                    )
                    
                    
                    1,812
                    
                    
                    
                    1,199Interest
      expense:Savings
      accounts
                    
                    
                    29
                    
                    
                    
                    (3
                    )
                    
                    
                    26
                    
                    
                    
                    43
                    
                    
                    
                    25
                    
                    
                    
                    68NOW
      and money market accounts
                    
                    
                    249
                    
                    
                    
                    216
                    
                    
                    
                    465
                    
                    
                    
                    567
                    
                    
                    
                    423
                    
                    
                    
                    990Certificates
      of deposit and other time deposits
                    
                    
                    (1,049
                    )
                    
                    
                    1,102
                    
                    
                    
                    53
                    
                    
                    
                    (2,209
                    )
                    
                    
                    2,064
                    
                    
                    
                    (145
                    )Short
      term borrowings
                    
                    
                    55
                    
                    
                    
                    (91
                    )
                    
                    
                    (36
                    )
                    
                    
                    116
                    
                    
                    
                    (174
                    )
                    
                    
                    (58
                    )FHLB
      advances
                    
                    
                    (2
                    )
                    
                    
                    (2
                    )
                    
                    
                    (4
                    )
                    
                    
                    (7
                    )
                    
                    
                    (1
                    )
                    
                    
                    (8
                    )Subordinated
      debentures
                    
                    
                    2
                    
                    
                    
                    -
                    
                    
                    
                    2
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Total
      interest bearing liabilities
                    
                    
                    (716
                    )
                    
                    
                    1,222
                    
                    
                    
                    506
                    
                    
                    
                    (1,490
                    )
                    
                    
                    2,337
                    
                    
                    
                    847Net
      change in net interest income
                    
                    $
                    820
                    
                    
                    $
                    (514
                    )
                    
                    $
                    306
                    
                    
                    $
                    877
                    
                    
                    $
                    (525
                    )
                    
                    $
                    352





Non-Interest
Income and Non-Interest Expense





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





Three Months EndedJune 30,(Dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    Change
                    
                    
                    %Non-interest
      incomeCustomer
      service fees on deposit accounts
                    
                    $
                    1,739
                    
                    
                    $
                    1,645
                    
                    
                    $
                    94
                    
                    
                    
                    5.7
                    %Gain
      on sale of mortgage loans
                    
                    
                    415
                    
                    
                    
                    355
                    
                    
                    
                    60
                    
                    
                    
                    16.9
                    %Net
      impairment losses recognized in earnings
                    
                    
                    (11
                    )
                    
                    
                    (245
                    )
                    
                    
                    234
                    
                    
                    
                    -95.5
                    %Loss
      on sale and write downs of real estate acquired  through
      foreclosure
                    
                    
                    (438
                    )
                    
                    
                    (233
                    )
                    
                    
                    (205
                    )
                    
                    
                    88.0
                    %Brokerage
      commissions
                    
                    
                    107
                    
                    
                    
                    99
                    
                    
                    
                    8
                    
                    
                    
                    8.1
                    %Other
      income
                    
                    
                    369
                    
                    
                    
                    469
                    
                    
                    
                    (100
                    )
                    
                    
                    -21.3
                    %$
                    2,181
                    
                    
                    $
                    2,090
                    
                    
                    $
                    91
                    
                    
                    
                    4.4
                    %


28




Six Months EndedJune 30,(Dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    Change
                    
                    
                    %Non-interest
      incomeCustomer
      service fees on deposit accounts
                    
                    $
                    3,264
                    
                    
                    $
                    3,122
                    
                    
                    $
                    142
                    
                    
                    
                    4.5
                    %Gain
      on sale of mortgage loans
                    
                    
                    714
                    
                    
                    
                    532
                    
                    
                    
                    182
                    
                    
                    
                    34.2
                    %Loss
      on sale of investments
                    
                    
                    (23
                    )
                    
                    
                    -
                    
                    
                    
                    (23
                    )
                    
                    
                    100.0
                    %Net
      impairment losses recognized in earnings
                    
                    
                    (183
                    )
                    
                    
                    (400
                    )
                    
                    
                    217
                    
                    
                    
                    -54.3
                    %Loss
      on sale and write downs of real estate acquired  through
      foreclosure
                    
                    
                    (464
                    )
                    
                    
                    (250
                    )
                    
                    
                    (214
                    )
                    
                    
                    85.6
                    %Brokerage
      commissions
                    
                    
                    200
                    
                    
                    
                    192
                    
                    
                    
                    8
                    
                    
                    
                    4.2
                    %Other
      income
                    
                    
                    811
                    
                    
                    
                    897
                    
                    
                    
                    (86
                    )
                    
                    
                    -9.6
                    %$
                    4,319
                    
                    
                    $
                    4,093
                    
                    
                    $
                    226
                    
                    
                    
                    5.5
                    %





Growth in
customer service fees on deposit accounts, our largest component of non-interest
income, is primarily due to growth in customer deposits and overdraft fee income
on retail checking accounts for 2010.  We continue to increase our
customer base through cross-selling opportunities and marketing initiatives and
promotions.  In addition, we continue to emphasize growing our
checking account base to better enhance our profitability and franchise
value.





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





We invest
in various types of liquid assets, including United States Treasury obligations,
securities of various federal agencies, obligations of states and political
subdivisions, corporate bonds, mutual funds, stocks and
others.  During 2010 we recorded a loss on the sale of an equity
investment security of $23,000.





We
recognized other-than-temporary impairment charges of $183,000 for the expected
credit loss during the 2010 period on three of our trust preferred securities
compared to $400,000 of impairment charges for 2009. Management believes this
impairment was primarily attributable to the current economic environment which
caused the financial conditions of some of the issuers to
deteriorate.





Further
reducing non-interest income for 2010 was an increase of $214,000 in losses on
the sale and write down of real estate owned properties and decreases in other
income due to a decline in fees associated with our mortgage loan
operations.




Three Months EndedJune 30,(Dollars in thousands)
                    
                    2010
                    
                    
                    2009
                    
                    
                    Change
                    
                    
                    %Non-interest
      expensesEmployee
      compensation and benefits
                    
                    $
                    3,905
                    
                    
                    $
                    4,149
                    
                    
                    $
                    (244
                    )
                    
                    
                    -5.9
                    %Office
      occupancy expense and equipment
                    
                    
                    768
                    
                    
                    
                    808
                    
                    
                    
                    (40
                    )
                    
                    
                    -5.0
                    %Marketing
      and advertising
                    
                    
                    225
                    
                    
                    
                    245
                    
                    
                    
                    (20
                    )
                    
                    
                    -8.2
                    %Outside
      services and data processing
                    
                    
                    668
                    
                    
                    
                    795
                    
                    
                    
                    (127
                    )
                    
                    
                    -16.0
                    %Bank
      franchise tax
                    
                    
                    566
                    
                    
                    
                    257
                    
                    
                    
                    309
                    
                    
                    
                    120.2
                    %FDIC
      insurance premiums
                    
                    
                    694
                    
                    
                    
                    788
                    
                    
                    
                    (94
                    )
                    
                    
                    -11.9
                    %Amortization
      of core deposit intangible
                    
                    
                    88
                    
                    
                    
                    101
                    
                    
                    
                    (13
                    )
                    
                    
                    -12.9
                    %Other
      expense
                    
                    
                    1,720
                    
                    
                    
                    1,301
                    
                    
                    
                    419
                    
                    
                    
                    32.2
                    %$
                    8,634
                    
                    
                    $
                    8,444
                    
                    
                    $
                    190
                    
                    
                    
                    2.3
                    %


29





Six Months EndedJune 30,(Dollars in thousands)
                      
                      2010
                      
                      
                      2009
                      
                      
                      Change
                      
                      
                      %Non-interest
      expensesEmployee
      compensation and benefits
                      
                      $
                      7,995
                      
                      
                      $
                      8,151
                      
                      
                      $
                      (156
                      )
                      
                      
                      -1.9
                      %Office
      occupancy expense and equipment
                      
                      
                      1,572
                      
                      
                      
                      1,656
                      
                      
                      
                      (84
                      )
                      
                      
                      -5.1
                      %Marketing
      and advertising
                      
                      
                      450
                      
                      
                      
                      510
                      
                      
                      
                      (60
                      )
                      
                      
                      -11.8
                      %Outside
      services and data processing
                      
                      
                      1,398
                      
                      
                      
                      1,588
                      
                      
                      
                      (190
                      )
                      
                      
                      -12.0
                      %Bank
      franchise tax
                      
                      
                      916
                      
                      
                      
                      521
                      
                      
                      
                      395
                      
                      
                      
                      75.8
                      %FDIC
      insurance premiums
                      
                      
                      1,354
                      
                      
                      
                      967
                      
                      
                      
                      387
                      
                      
                      
                      40.0
                      %Amortization
      of core deposit intangible
                      
                      
                      152
                      
                      
                      
                      202
                      
                      
                      
                      (50
                      )
                      
                      
                      -24.8
                      %Other
      expense
                      
                      
                      3,071
                      
                      
                      
                      2,632
                      
                      
                      
                      439
                      
                      
                      
                      16.7
                      %$
                      16,908
                      
                      
                      $
                      16,227
                      
                      
                      $
                      681
                      
                      
                      
                      4.2
                      %





Employee
compensation and benefits is the largest component of non-interest
expense.  Decreases for 2010 were due to reductions in benefits
expense.





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





During
the fourth quarter of 2009, the FDIC adopted a requirement that all banks prepay
three and a quarter years worth of FDIC assessments on December 31,
2009.  The prepayment is based on average third quarter
deposits.  The prepaid amount will be amortized over the prepayment
period.  Our prepayment was $7.5 million of which $1.3 million was
reflected in our 2010 income statement.  Given the enacted increases
in
assessments  for  insured  financial  institutions  in  2009,  we
anticipate  that  FDIC  assessments  on
deposits will have a significantly greater impact upon operating expenses for
the next few years.





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





Our
efficiency ratio was 74% for 2010 compared to 73% for the 2009
period.





ANALYSIS
OF FINANCIAL CONDITION





Total
assets at June 30, 2010 increased $29.7 million from December 31, 2009. The
increase was due to building our investment portfolio to $145.1 million, an
increase of $98.2 million since December 31, 2009.  This increase was
mainly off-set by a decline in gross loans of $54.3 million and a decrease in
cash and cash equivalents of $23.8 million.  This shift in the balance
sheet reflects a conscious effort by management to add on-balance sheet
liquidity to protect us against any adverse changes to our current wholesale
funding position.





Loans





Net loans
decreased $50.7 million to $934.7 million at June 30, 2010 compared to $985.4
million at December 31, 2009.  Our commercial real estate and
commercial portfolios decreased $45.7 million to $645.0 million at June 30,
2010.  Our residential mortgage loan, real estate construction and
indirect consumer portfolios all decreased for the 2010 period while our
consumer and home equity loan portfolio remained relatively
constant.  The decline in our commercial real estate and commercial
loan portfolios is a result of pay-offs on several large commercial
relationships.  Although there remains a high demand for loans from
quality borrowers, we have elected to shift our focus to preserve capital during
the current economic slow-down.  We believe however, we will still be
well positioned to benefit from growth in our local markets when the economy
rebounds.


30




June 30,
                  
                  
                  December 31,(Dollars in thousands)
                  
                  2010
                  
                  
                  2009Commercial
                  
                  $
                  53,470
                  
                  
                  $
                  62,940Real
      estate commercial
                  
                  
                  591,556
                  
                  
                  
                  627,788Real
      estate construction
                  
                  
                  12,982
                  
                  
                  
                  14,567Residential
      mortgage
                  
                  
                  174,306
                  
                  
                  
                  178,985Consumer
      and home equity
                  
                  
                  75,818
                  
                  
                  
                  74,844Indirect
      consumer
                  
                  
                  33,087
                  
                  
                  
                  36,628Loans
      held for sale
                  
                  
                  14,997
                  
                  
                  
                  8,183956,216
                  
                  
                  
                  1,003,935Less:Net
      deferred loan origination fees
                  
                  
                  (588
                  )
                  
                  
                  (826
                  )Allowance
      for loan losses
                  
                  
                  (20,953
                  )
                  
                  
                  (17,719
                  )(21,541
                  )
                  
                  
                  (18,545
                  )Loans
      Receivable
                  
                  $
                  934,675
                  
                  
                  $
                  985,390





Allowance
and Provision for Loan Losses





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





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





2008 was
a tumultuous year for the U.S. economy and the financial service industry.
Declining property values led to declining valuations for loan
portfolios.  The property value declines, which began in the second
half of 2007, continued throughout 2009.  The markets we serve have
generally avoided the severe property value declines experienced in other parts
of the country; nonetheless, the impact in our markets was still
significant.  During the second half of 2008, throughout 2009 and
continuing into the first half of 2010, we substantially increased our provision
for loan losses for our general and specific reserves as we identified adverse
developments.  2010 will continue to be a challenging time for our
financial institution as we manage the overall level of our credit
quality.  It is likely that provision for loan losses will remain
elevated in the near term.


31


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





Three Months Ended
                  
                  
                  Six Months EndedJune 30,
                  
                  
                  June 30,(Dollars in thousands)
                  
                  2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Balance
      at beginning of period
                  
                  $
                  18,810
                  
                  
                  $
                  15,072
                  
                  
                  $
                  17,719
                  
                  
                  $
                  13,565Loans
      charged-off:Real
      estate mortgage
                  
                  
                  1,040
                  
                  
                  
                  41
                  
                  
                  
                  1,583
                  
                  
                  
                  41Consumer
                  
                  
                  153
                  
                  
                  
                  170
                  
                  
                  
                  321
                  
                  
                  
                  486Commercial
                  
                  
                  -
                  
                  
                  
                  2,602
                  
                  
                  
                  -
                  
                  
                  
                  2,879Total
      charge-offs
                  
                  
                  1,193
                  
                  
                  
                  2,813
                  
                  
                  
                  1,904
                  
                  
                  
                  3,406Recoveries:Real
      estate mortgage
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  -
                  
                  
                  
                  2Consumer
                  
                  
                  53
                  
                  
                  
                  64
                  
                  
                  
                  97
                  
                  
                  
                  117Commercial
                  
                  
                  9
                  
                  
                  
                  -
                  
                  
                  
                  15
                  
                  
                  
                  -Total
      recoveries
                  
                  
                  62
                  
                  
                  
                  64
                  
                  
                  
                  112
                  
                  
                  
                  119Net
      loans charged-off
                  
                  
                  1,131
                  
                  
                  
                  2,749
                  
                  
                  
                  1,792
                  
                  
                  
                  3,287Provision
      for loan losses
                  
                  
                  3,274
                  
                  
                  
                  1,913
                  
                  
                  
                  5,026
                  
                  
                  
                  3,958Balance
      at end of period
                  
                  $
                  20,953
                  
                  
                  $
                  14,236
                  
                  
                  $
                  20,953
                  
                  
                  $
                  14,236Allowance
      for loan losses to total loans (excluding loans held for
    sale)
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2.23
                  %
                  
                  
                  1.46
                  %Annualized
      net charge-offs to average loans outstanding
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  0.37
                  %
                  
                  
                  0.70
                  %Allowance
      for loan losses to total non-performing loans
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  57
                  %
                  
                  
                  54
                  %





The
provision for loan losses increased $1.4 million to $3.3 million for the quarter
ended June 30, 2010, and increased $1.1 million to $5.0 million for the six
months ended June 30, 2010 compared to the same periods in
2009.  During the first half of 2010, we continued our efforts to
ensure the adequacy of the allowance by adding specific reserves to several
large commercial real estate relationships based on updated appraisals of the
underlying collateral.  Offsetting this increase was a small decrease
in the general reserve provisioning levels due to the decline in the loan
portfolio.  The allowance for loan losses increased $6.7 million to
$21.0 million from June 30, 2009 to June 30, 2010. The increase was due to
specific reserves placed on loans due to updated appraisal information, as well
as the provision recorded to reflect an increase in classified loans for the
2010 period





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





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





June 30,
                    
                    
                    March 31,
                    
                    
                    December 31,
                    
                    
                    June 30,
                    
                    
                    June 30,(Dollars in thousands)
                    
                    2010
                    
                    
                    2010
                    
                    
                    2009
                    
                    
                    2009
                    
                    
                    2008Classified LoansSubstandard
                    
                    $
                    74,305
                    
                    
                    $
                    65,028
                    
                    
                    $
                    65,408
                    
                    
                    $
                    63,134
                    
                    
                    $
                    35,746Doubtful
                    
                    
                    463
                    
                    
                    
                    407
                    
                    
                    
                    370
                    
                    
                    
                    1,039
                    
                    
                    
                    -Loss
                    
                    
                    231
                    
                    
                    
                    26
                    
                    
                    
                    1,178
                    
                    
                    
                    305
                    
                    
                    
                    52Total
      Classified
                    
                    $
                    74,999
                    
                    
                    $
                    65,461
                    
                    
                    $
                    66,956
                    
                    
                    $
                    64,478
                    
                    
                    $
                    35,798


32


As we
focused on credit quality during 2008, 2009 and the first half of 2010, there
was a significant migration of loans into the Substandard loan
category.  If economic conditions continue to put stress on our
borrowers going forward, this may require higher provisions for loan losses in
future periods.  We expect that the economy will remain weak at least
for the next several quarters.  Credit quality will continue to be a
primary focus in 2010 and going forward.





The $11.2
million increase in substandard assets for 2010 was primarily the resultof downgrading loans
withten borrowers
with balances ranging from $939,000 million to $8.6 million.Offsetting this increase
was the transfer of three classified loans totaling $7.4 million to real estate
acquired through foreclosure and the upgrades of four classified loans totaling
$10.5 million whose cash flow is adequate to service the debt. Approximately
$47.9 million of the total classified loans were related to real estate
development or real estate construction loans in our market
area.  Classified consumer loans totaled $1.4 million, classified
mortgage loans totaled $5.0 million andclassified commercial
loans totaled $20.7 million.  For more information on collection
efforts, evaluation of collateral and how loss amounts are estimated, see
“Non-Performing Assets,” below.





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





Non-Performing
Assets





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





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





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





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





Real
estate owned acquired through foreclosure is recorded at fair value less
estimated selling costs at the date of foreclosure.  Fair value is
based on the appraised market value of the property based on sales of similar
assets.  The fair value may be subsequently reduced if the estimated
fair value declines below the original appraised value. Real estate acquired
through foreclosure increased $6.3 million to $14.7 million at June 30,
2010.  The increase was primarily the result of foreclosures involving
four commercial credit relationships totaling $6.6 million that was transferred
during the first half of 2010.


33




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





June 30,
                                      
                                      
                                      December 31,(Dollar in thousands)
                                      
                                      2010
                                      
                                      
                                      2009Restructured
                                      
                                      $
                                      1,321
                                      
                                      
                                      $
                                      9,812Past
      due 90 days still on accrual
                                      
                                      
                                      -
                                      
                                      
                                      
                                      -Loans
      on non-accrual status
                                      
                                      
                                      35,707
                                      
                                      
                                      
                                      28,186Total
      non-performing loans
                                      
                                      
                                      37,028
                                      
                                      
                                      
                                      37,998Real
      estate acquired through foreclosure
                                      
                                      
                                      14,703
                                      
                                      
                                      
                                      8,428Other
      repossessed assets
                                      
                                      
                                      151
                                      
                                      
                                      
                                      103Total
      non-performing assets
                                      
                                      $
                                      51,882
                                      
                                      
                                      $
                                      46,529Interest
      income that would have been earnedon
      non-performing loans
                                      
                                      $
                                      2,166
                                      
                                      
                                      $
                                      2,234Interest
      income recognized on non-performingloans
                                      
                                      
                                      265
                                      
                                      
                                      
                                      211Ratios:   Non-performing
      loans to total loans (excluding loans held for sale)
                                      
                                      
                                      3.94
                                      %
                                      
                                      
                                      3.82
                                      %Non-performing
      assets to total assets
                                      
                                      
                                      4.18
                                      %
                                      
                                      
                                      3.85
                                      %





Non-performing
loans decreased $970,000 to $37.0 million at June 30, 2010 compared to $38.0
million at December 31, 2009.  Non-accrual loans increased due to the
addition of five credit relationships totaling $19.5
million.  Offsetting this increase was a $5.1 credit relationship
being removed from the non-accrual category when the loan was re-written with
new guarantors and three non-accrual relationships totaling $6.6 million were
transferred to real estate acquired through foreclosure.  These credit
relationships are secured by real estate and we have provided adequate allowance
based on current information.  All non-performing loans are considered
impaired.





Non-performing
assets for the 2010 period include $1.3 million in restructured commercial,
mortgage and consumer loans.  Our restructured loans primarily consist
of six credit relationships with balances ranging from $113,000 to
$238,000.  The terms of these loans have been renegotiated to reduce
the rate of interest or extend the term, thus reducing the amount of cash flow
required from the borrower to service the loans. The borrowers are currently
meeting the terms of the restructured loans.  The decrease in
restructured loans from December 31, 2009 is due to a credit relationship
totaling $6.1 million that was transferred to non-accrual status. Additional
decreases include the removal of two credit relationships totaling $3.2 million
from the restructured category since the terms of the loans are now
substantially equivalent to terms on which loans with comparable risks are being
made and the borrowers have performed according to the terms of the contract for
the past 18 to 24 months.





Investment
Securities





Interest
on securities provides us our largest source of interest income after interest
on loans, constituting 5.8% of the total interest income for the six month
period ended June 30, 2010.  The securities portfolio serves as a
source of liquidity and earnings and contributes to the management of interest
rate risk.  We have the authority to invest in various types of liquid
assets, including short-term United States Treasury obligations and securities
of various federal agencies, obligations of states and political subdivisions,
corporate bonds, certificates of deposit at insured savings and loans and banks,
bankers' acceptances, and federal funds.  We may also invest a portion
of our assets in certain commercial paper and corporate debt
securities.  We are also authorized to invest in mutual funds and
stocks whose assets conform to the investments that we are authorized to make
directly. The available-for-sale investment portfolio increased $99.0 million
due to our purchase of government-sponsored mortgage-backed securities, U.S.
Government agency securities and state and municipal obligations. The
held-to-maturity investment portfolio decreased $789,000 as securities were
called for redemption in accordance with their terms due to decreasing
rates.





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


34


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





We have
evaluated the decline in the fair value of the trust preferred securities we
hold, which are directly related to the credit and liquidity crisis being
experienced in the financial services industry over the past
year.   The trust preferred securities market is currently
inactive making the valuation of trust preferred securities very
difficult.  The trust preferred securities are valued by management
using unobservable inputs through a discounted cash flow analysis as permitted
under current accounting guidance and using the expected cash flows
appropriately discounted using present value techniques.   Refer to
Note 6 – Fair Value for more information.





We
recognized other-than-temporary impairment charges of $183,000 for the expected
credit loss during the 2010 period on three of the trust preferred securities we
hold with an original cost basis of $1.8 million.  All of our trust
preferred securities are currently rated below investment grade. One of our
trust preferred securities continues to pay interest as scheduled through June
30, 2010, and is expected to continue paying interest as
scheduled.  The other four trust preferred securities are paying
either partial or full interest in kind instead of full cash
interest.    See Note 2 – Securities for more
information.  Management will continue to evaluate these securities
for impairment quarterly.




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





Deposits





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





Total
deposits increased $29.5 million year to date compared to December 31, 2009 due
to successful deposit promotions.  Retail and commercial deposits
increased $115.5 million.  Public funds, brokered deposits and
Certificate of Deposit Account Registry Service (“CDARS”) certificates
decreased$86.0
million.  Brokered deposits were $88.7 million at June 30, 2010
compared to $127.8 million at December 31, 2009.





The
following table breaks down our deposits.





June 30,
                      
                      
                      December 31,2010
                      
                      
                      2009(In Thousands)Non-interest
      bearing
                      
                      $
                      70,204
                      
                      
                      $
                      63,950NOW
      demand
                      
                      
                      111,909
                      
                      
                      
                      117,319Savings
                      
                      
                      103,943
                      
                      
                      
                      131,401Money
      market
                      
                      
                      137,576
                      
                      
                      
                      127,885Certificates
      of deposit
                      
                      
                      655,653
                      
                      
                      
                      609,260$
                      1,079,285
                      
                      
                      $
                      1,049,815


35


Short-Term
Borrowings





Short-term
borrowings consist of a loan agreement with a correspondent bank for 2010 and
primarily federal funds purchased from the FHLB of Cincinnati for
2009.  We had short-term borrowings of $595,000 at June 30, 2010 and
$114.6 million at June 30, 2009.  These borrowings averaged a rate of
7.76% and .25% for 2010 and 2009.





Advances
from Federal Home Loan Bank





Deposits
are the primary source of funds for our lending and investment activities and
for our general business purposes.  We can also use advances
(borrowings) from the Federal Home Loan Bank (FHLB) of Cincinnati to compensate
for reductions in deposits or deposit inflows at less than projected
levels.  Advances from the FHLB are secured by our stock in the FHLB,
certain securities, certain commercial real estate loans and substantially all
of our first mortgage, multi-family and open end home equity
loans.  At June 30, 2010 we had $52.6 million in advances outstanding
from the FHLB.





Subordinated
Debentures





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





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





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





LIQUIDITY





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





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


36


At the
holding company level, the Corporation uses cash to pay dividends to
stockholders, repurchase common stock, make selected investments and
acquisitions, and service debt. The main sources of funding for the Corporation
include dividends from the Bank, borrowings and access to the capital
markets.  The Corporation maintains a loan agreement with a
correspondent bank.  As of June 30, 2010, the outstanding balance of
this loan was $595,000.  The loan matures on January 31, 2011 and
principal and interest of $ 86,000 is due monthly at a rate of prime plus one
percent with a floor of 6.00%.





The
primary source of funding for the Corporation has been dividends and returns of
investment from the Bank. Kentucky banking laws limit the amount of dividends
that may be paid to the Corporation by the Bank without prior approval of the
KDFI.  Under these laws, the amount of dividends that may be paid in
any calendar year is limited to current year’s net income, as defined in the
laws, combined with the retained net income of the preceding two years, less any
dividends declared during those periods.The Bank currently has a
regulatory agreement with the FDIC that requires us to obtain the consent of the
Regional Director of the FDIC and the Commissioner of the KDFI to declare and
pay cash dividends.  The Corporation has also entered into an
agreement with the Federal Reserve to obtain regulatory approval before
declaring any dividends.  We may not redeem shares or obtain
additional borrowings without prior approval.  Because of these
limitations, consolidated cash flows as presented in the consolidated statements
of cash flows may not represent cash immediately available to the
Corporation.  During 2010, the Bank declared and paid dividends of
$1.2 million to the Corporation.





CAPITAL





Stockholders’
equity increased $1.4 million for the period ended June 30, 2010 compared to
December 31, 2009 primarily due to net income earned during the period and the
decrease in unrealized losses on securities available-for-sale.  Our
average stockholders’ equity to average assets ratio decreased to 6.93% for the
six months ended June 30, 2010 compared to 8.73% for 2009.





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





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





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





Each of
the federal bank regulatory agencies has established minimum leverage capital
requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to
adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank
regulatory evaluation of an organization’s overall safety and
soundness.  We intend to maintain a capital position that meets or
exceeds the “well capitalized” requirements established for banks by the
FDIC.  We currently have a regulatory agreement with the FDIC that
requires us to maintain a Tier 1 leverage ratio of 8%.  We are
currently in compliance with the Tier 1 capital requirement.


37


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





To Be ConsideredWell CapitalizedUnder Prompt(Dollars in thousands)
                  
                  
                  
                  
                  
                  
                  
                  For Capital
                  
                  
                  CorrectionActual
                  
                  
                  Adequacy Purposes
                  
                  
                  Action ProvisionsAs
      of June 30, 2010:
                  
                  Amount
                  
                  
                  Ratio
                  
                  
                  Amount
                  
                  
                  Ratio
                  
                  
                  Amount
                  
                  
                  RatioTotal
      risk-based capital (to risk-weighted assets)Consolidated
                  
                  $
                  115,662
                  
                  
                  
                  11.86
                  %
                  
                  $
                  78,024
                  
                  
                  
                  8.00
                  %
                  
                  
                  N/A
                  
                  
                  
                  N/ABank
                  
                  
                  114,800
                  
                  
                  
                  11.78
                  
                  
                  
                  77,977
                  
                  
                  
                  8.00
                  
                  
                  
                  97,472
                  
                  
                  
                  10.00Tier
      I capital (to risk-weighted assets)Consolidated
                  
                  
                  103,363
                  
                  
                  
                  10.60
                  
                  
                  
                  39,012
                  
                  
                  
                  4.00
                  
                  
                  
                  N/A
                  
                  
                  
                  N/ABank
                  
                  
                  102,508
                  
                  
                  
                  10.52
                  
                  
                  
                  38,989
                  
                  
                  
                  4.00
                  
                  
                  
                  58,483
                  
                  
                  
                  6.00Tier
      I capital (to average assets)Consolidated
                  
                  
                  103,363
                  
                  
                  
                  8.20
                  
                  
                  
                  50,394
                  
                  
                  
                  4.00
                  
                  
                  
                  N/A
                  
                  
                  
                  N/ABank
                  
                  
                  102,508
                  
                  
                  
                  8.13
                  
                  
                  
                  50,404
                  
                  
                  
                  4.00
                  
                  
                  
                  63,005
                  
                  
                  
                  5.00





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





Item
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





Asset/Liability
Management and Market Risk





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





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


38


Our
interest sensitivity profile was asset sensitive at June 30, 2010 and December
31, 2009.  Given a sustained 100 basis point decrease in rates, our
base net interest income would decrease by an estimated.76% at June 30, 2010
compared to a decrease of 2.84% at December 31, 2009. Given a 100 basis point
increase in interest rates our base net interest income would increase by
anestimated 1.93%
at June 30, 2010 compared to an increase of 2.70% at December 31,
2009.





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





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





June 30, 2010Decrease in Rates
                                
                                
                                
                                
                                
                                Increase in Rates200
                                
                                
                                100
                                
                                
                                
                                
                                
                                100
                                
                                
                                200(Dollars in thousands)
                                
                                Basis Points
                                
                                
                                Basis Points
                                
                                
                                Base
                                
                                
                                Basis Points
                                
                                
                                Basis PointsProjected
      interest incomeLoans
                                
                                $
                                51,271
                                
                                
                                $
                                52,257
                                
                                
                                $
                                53,236
                                
                                
                                $
                                54,240
                                
                                
                                $
                                55,218Investments
                                
                                
                                5,375
                                
                                
                                
                                5,510
                                
                                
                                
                                5,378
                                
                                
                                
                                5,923
                                
                                
                                
                                6,456Total
      interest income
                                
                                
                                56,646
                                
                                
                                
                                57,767
                                
                                
                                
                                58,613
                                
                                
                                
                                60,162
                                
                                
                                
                                61,674Projected
      interest expenseDeposits
                                
                                
                                18,202
                                
                                
                                
                                18,146
                                
                                
                                
                                18,719
                                
                                
                                
                                19,553
                                
                                
                                
                                20,388Borrowed
      funds
                                
                                
                                3,672
                                
                                
                                
                                3,672
                                
                                
                                
                                3,672
                                
                                
                                
                                3,687
                                
                                
                                
                                3,701Total
      interest expense
                                
                                
                                21,874
                                
                                
                                
                                21,818
                                
                                
                                
                                22,391
                                
                                
                                
                                23,240
                                
                                
                                
                                24,089Net
      interest income
                                
                                $
                                34,772
                                
                                
                                $
                                35,949
                                
                                
                                $
                                36,223
                                
                                
                                $
                                36,922
                                
                                
                                $
                                37,585Change
      from base
                                
                                $
                                (1,451
                                )
                                
                                $
                                (274
                                )
                                
                                
                                
                                
                                
                                $
                                699
                                
                                
                                $
                                1,362%
      Change from base
                                
                                
                                (4.01
                                )%
                                
                                
                                (0.76
                                )%
                                
                                
                                
                                
                                
                                
                                1.93
                                %
                                
                                
                                3.76
                                %





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


39


Item
4.  CONTROLS AND PROCEDURES





Management
is responsible for establishing and maintaining effective disclosure controls
and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities
Exchange Act of 1934. As of June 30, 2010, an evaluation was performed under the
supervision and with the participation of management, including the Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures. Based on that
evaluation, management concluded that disclosure controls and procedures as of
June 30, 2010 were effective in ensuring material information required to be
disclosed in this Annual Report on Form 10-Q was recorded, processed,
summarized, and reported in a timely manner as specified in SEC rules and
forms.





There
were no significant changes in our internal controls or in other factors that
could significantly affect these controls after the date of the Chief Executive
Officer and Chief Financial Officers evaluation, nor were there any significant
deficiencies or material weaknesses in the controls which required corrective
action.





Part
II - OTHER INFORMATION





Item 1.
              Legal
      Proceedings





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





Item 1A.
              Risk
      Factors





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





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





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





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





The
impact of financial reform legislation on us is uncertain.




The
recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act
institutes a wide range of reforms that will have an impact on all financial
institutions.  Changes to the deposit insurance and financial
regulatory systems, enhanced bank capital requirements and new regulations
designed to protect consumers in financial transactions are only a few of the
provisions of the Act.  Many of these provisions are subject to rule
making procedures and studies that will be conducted in the
future.  Accordingly, we cannot assess the impact the Act will have on
us at the present time.


40


In
the future, we may have to suspend payment of dividends on the outstanding
shares of preferred stock issued to the United States Department of the
Treasury.





In
January 2009, we issued $20 million in preferred stock to the United States
Department of the Treasury as part of Treasury’s Capital Purchase Program. The
preferred stock accrues cumulative dividends quarterly at a rate of 5% per annum
during the first five years (approximately $1 million annually), and 9% per
annum thereafter (approximately $1.8 million annually). If we fail to pay
dividends on the preferred stock for six or more dividend periods, the holders
of the preferred stock will have the right to elect two directors to fill two
newly created directorships. This right and the terms of the new directorships
will continue until such time as we have paid in full all accrued and unpaid
dividends on the preferred stock for all past dividend periods. In addition, all
accrued but unpaid amounts will accumulate as a liability on our balance
sheet.





In
the future, we may have to defer payments on our trust preferred
securities.





We may
defer interest payments on our trust preferred securities for a total of 20
consecutive calendar quarters without causing an event of default under the
documents governing these securities. After such period, we must pay all
deferred interest and resume quarterly interest payments or we will be in
default. If we defer payments on our trust preferred securities, all accrued but
unpaid amounts will accumulate as a liability on our balance sheet.





Item 2.
              Unregistered
      Sales of Securities and Use of
Proceeds





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





Item 3.
              Defaults
      Upon Senior Securities





Not
Applicable





Item 4.
              Reserved





Item 5.
              Other
      Information





None





Item 6.
              Exhibits:





31.1
            Certification
      of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley
      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)


41


FIRST
FINANCIAL SERVICE CORPORATION





SIGNATURES





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





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


42


INDEX
TO EXHIBITS





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


43