Table of Contents

 

 

 

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

 

**Commission File Number 0-18832**

 

**First Financial Service Corporation**

(Exact Name of Registrant as specified in its charter)

 

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

 

**2323 Ring Road**

**Elizabethtown, Kentucky  42701**

(Address of principal executive offices)

(Zip Code)

 

**(270) 765-2131**

(Registrant’s telephone number, including area code)

 

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

 

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

 
| Large  Accelerated Filer o | Accelerated  Filer **x** | Non-Accelerated  Filer o           | Smaller  Reporting Company o |
|---------------------------------|--------------------------|-----------------------------------------|-----------------------------------|
|                            |                     |   (Do  not check if a smaller |                              |
|                            |                     |   reporting  company)         |                              |

 

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

 

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

 

| **Class**    | ** ** | **Outstanding as of July 31, 2008** |
|--------------|------------|--------------------------------------------------------------|
|         |       |                                                         |
| Common Stock |       | 4,664,235****shares                                          |

 

 

 

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Table of Contents

 

## **FIRST FINANCIAL SERVICE CORPORATION**

**FORM 10-Q**

**TABLE OF CONTENTS**

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

 

2

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**PRELIMINARY NOTE REGARDING**

**FORWARD-LOOKING STATEMENTS**

 

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

 

Various risks and uncertainties may cause actualresults to differ materially from those indicated by our forward-lookingstatements.  In addition to those risksdescribed under “Item 1A Risk Factors,” of this report and our Annual Report onForm 10-K, the following factors could cause such differences: changes ingeneral economic conditions and economic conditions in Kentucky and the marketswe serve, any of which may affect, among other things, our level ofnon-performing assets, charge-offs, and provision for loan loss expense;changes in interest rates that may reduce interest margins and impact fundingsources; changes in market rates and prices which may adversely impact the valueof financial products including securities, loans and deposits; changes in taxlaws, rules and regulations; various monetary and fiscal policies andregulations, including those determined by the Federal Reserve Board, theFederal Deposit Insurance Corporation (“FDIC”) and the Kentucky Office ofFinancial Institutions (“KOFI”); competition with other local and regionalcommercial banks, savings banks, credit unions and other non-bank financialinstitutions; our ability to grow core businesses; our ability to develop andintroduce new banking-related products, services and enhancements and gainmarket acceptance of such products; and management’s ability to manage theseand other risks.

 

Our forward-looking statementsspeak only as of the date on which they are made, and we undertake noobligation to update any forward-looking statement to reflect events orcircumstances after the date of the statement to reflect the occurrence ofunanticipated events.

 

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**Item 1.                                                                FIRSTFINANCIAL SERVICE CORPORATION**

**Consolidated Balance Sheets**

**(Unaudited)**

 

 
| ** **                                                                                                                                                 | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(Dollars in thousands, except share data)**                                                                                     | ** ** | **2008**          | ** ** | **2007**              | ** ** |
|                                                                                                                                                       |       |              |       |                  |       |
| **ASSETS:**                                                                                                                                                |       |              |       |                  |       |
| Cash and due from banks                                                                                                                                    |       | $                 | 28,744     |                  | $          | 14,948 |   |
| Federal funds sold                                                                                                                                         |       | 6,950             |       | —                |       |
| Cash and cash equivalents                                                                                                                                  |       | 35,694            |       | 14,948                |       |
|                                                                                                                                                       |       |              |       |                  |       |
| Securities available-for-sale                                                                                                                              |       | 19,980            |       | 22,004                |       |
| Securities held-to-maturity, fair value of  $8,308 (Jun 2008) and $17,624 (Dec 2007)                                                                       |       | 8,283             |       | 17,681                |       |
| Total securities                                                                                                                                           |       | 28,263            |       | 39,685                |       |
|                                                                                                                                                       |       |              |       |                  |       |
| Loans held for sale                                                                                                                                        |       | 3,186             |       | 780                   |       |
| Loans, net of unearned fees                                                                                                                                |       | 841,356           |       | 767,256               |       |
| Allowance for loan losses                                                                                                                                  |       | (8,917            | )          | (7,922                | )          |
| Net loans                                                                                                                                                  |       | 835,625           |       | 760,114               |       |
|                                                                                                                                                       |       |              |       |                  |       |
| Federal Home Loan Bank stock                                                                                                                               |       | 8,409             |       | 7,621                 |       |
| Cash surrender value of life insurance                                                                                                                     |       | 8,470             |       | 8,290                 |       |
| Premises and equipment, net                                                                                                                                |       | 29,446            |       | 26,335                |       |
| Real estate owned:                                                                                                                                         |       |              |       |                  |       |
| Acquired through foreclosure                                                                                                                               |       | 3,459             |       | 1,749                 |       |
| Held for development                                                                                                                                       |       | 45                |       | 45                    |       |
| Other repossessed assets                                                                                                                                   |       | 52                |       | 52                    |       |
| Goodwill                                                                                                                                                   |       | 12,262            |       | 8,384                 |       |
| Core deposit intangible                                                                                                                                    |       | 1,910             |       | —                |       |
| Accrued interest receivable                                                                                                                                |       | 4,249             |       | 4,324                 |       |
| Other assets                                                                                                                                               |       | 1,783             |       | 1,144                 |       |
|                                                                                                                                                       |       |              |       |                  |       |
| **TOTAL ASSETS**                                                                                                                                           |       | $                 | 969,667    |                  | $          | 872,691 |   |
|                                                                                                                                                       |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                              |       |              |       |                  |       |
| **LIABILITIES:**                                                                                                                                           |       |              |       |                  |       |
| Deposits:                                                                                                                                                  |       |              |       |                  |       |
| Non-interest bearing                                                                                                                                       |       | $                 | 77,124     |                  | $          | 46,978 |   |
| Interest bearing                                                                                                                                           |       | 707,962           |       | 642,265               |       |
| Total deposits                                                                                                                                             |       | 785,086           |       | 689,243               |       |
|                                                                                                                                                       |       |              |       |                  |       |
| Short-term borrowings                                                                                                                                      |       | 33,000            |       | 42,800                |       |
| Advances from Federal Home Loan Bank                                                                                                                       |       | 53,015            |       | 53,083                |       |
| Subordinated debentures                                                                                                                                    |       | 18,000            |       | 10,000                |       |
| Accrued interest payable                                                                                                                                   |       | 487               |       | 1,093                 |       |
| Accounts payable and other liabilities                                                                                                                     |       | 2,515             |       | 1,789                 |       |
| Deferred income taxes                                                                                                                                      |       | 1,872             |       | 1,223                 |       |
|                                                                                                                                                       |       |              |       |                  |       |
| **TOTAL LIABILITIES**                                                                                                                                      |       | 893,975           |       | 799,231               |       |
| Commitments and contingent liabilities                                                                                                                     |       | —            |       | —                |       |
|                                                                                                                                                       |       |              |       |                  |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                             |       |              |       |                  |       |
| Serial preferred stock, 5,000,000 shares authorized  and unissued                                                                                          |       | —            |       | —                |       |
| Common stock, $1 par value per share; authorized  10,000,000 shares; issued and outstanding, 4,664,235 shares (Jun 2008), and  4,661,083 shares (Dec 2007) |       | 4,664             |       | 4,661                 |       |
| Additional paid-in capital                                                                                                                                 |       | 34,018            |       | 33,886                |       |
| Retained earnings                                                                                                                                          |       | 37,435            |       | 35,225                |       |
| Accumulated other comprehensive loss                                                                                                                       |       | (425              | )          | (312                  | )          |
|                                                                                                                                                       |       |              |       |                  |       |
| **TOTAL STOCKHOLDERS’ EQUITY**                                                                                                                        |       | 75,692            |       | 73,460                |       |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                        |       | $                 | 969,667    |                  | $          | 872,691 |   |

 

*See notes to the unaudited consolidatedfinancial statements.*

 

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**FIRST FINANCIALSERVICE CORPORATION**

**ConsolidatedStatements of Income**

**(Unaudited)**

 
| ** **                                                                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                      | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(Dollars in thousands, except per share data)** | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| **Interest and Dividend Income:**                                               |       |                             |       |                           |       |   |   |   |   |
| Loans, including fees                                                           |       | $                                | 13,348     |                           | $          | 14,364 |   | $ | 27,380 |   | $ | 28,305 |   |
| Taxable securities                                                              |       | 309                              |       | 536                            |       | 693 |   | 1,148 |   |
| Tax exempt securities                                                           |       | 105                              |       | 107                            |       | 205 |   | 215 |   |
| Total interest income                                                           |       | 13,762                           |       | 15,007                         |       | 28,278 |   | 29,668 |   |
|                                                                            |       |                             |       |                           |       |   |   |   |   |
| **Interest Expense:**                                                           |       |                             |       |                           |       |   |   |   |   |
| Deposits                                                                        |       | 4,808                            |       | 6,440                          |       | 10,494 |   | 12,387 |   |
| Short-term borrowings                                                           |       | 183                              |       | 413                            |       | 505 |   | 988 |   |
| Federal Home Loan Bank advances                                                 |       | 601                              |       | 341                            |       | 1,197 |   | 676 |   |
| Subordinated debentures                                                         |       | 167                              |       | 154                            |       | 334 |   | 382 |   |
| Total interest expense                                                          |       | 5,759                            |       | 7,348                          |       | 12,530 |   | 14,433 |   |
|                                                                            |       |                             |       |                           |       |   |   |   |   |
| Net interest income                                                             |       | 8,003                            |       | 7,659                          |       | 15,748 |   | 15,235 |   |
| Provision for loan losses                                                       |       | 514                              |       | 127                            |       | 1,098 |   | 208 |   |
| Net interest income after provision for  loan losses                            |       | 7,489                            |       | 7,532                          |       | 14,650 |   | 15,027 |   |
|                                                                            |       |                             |       |                           |       |   |   |   |   |
| **Non-interest Income:**                                                        |       |                             |       |                           |       |   |   |   |   |
| Customer service fees on deposit accounts                                       |       | 1,632                            |       | 1,489                          |       | 3,048 |   | 2,763 |   |
| Gain on sale of mortgage loans                                                  |       | 239                              |       | 166                            |       | 387 |   | 292 |   |
| Gain on sale of real estate held for  development                               |       | —                           |       | —                         |       | — |   | 227 |   |
| Losses on securities transactions                                               |       | (216                             | )          | —                         |       | (216 | ) | — |   |
| Brokerage commissions                                                           |       | 125                              |       | 106                            |       | 243 |   | 202 |   |
| Other income                                                                    |       | 360                              |       | 278                            |       | 632 |   | 500 |   |
| Total non-interest income                                                       |       | 2,140                            |       | 2,039                          |       | 4,094 |   | 3,984 |   |
|                                                                            |       |                             |       |                           |       |   |   |   |   |
| **Non-interest Expense:**                                                       |       |                             |       |                           |       |   |   |   |   |
| Employee compensation and benefits                                              |       | 3,480                            |       | 3,105                          |       | 6,898 |   | 6,229 |   |
| Office occupancy expense and equipment                                          |       | 679                              |       | 596                            |       | 1,332 |   | 1,162 |   |
| Marketing and advertising                                                       |       | 209                              |       | 217                            |       | 423 |   | 449 |   |
| Outside services and data processing                                            |       | 766                              |       | 670                            |       | 1,483 |   | 1,336 |   |
| Bank franchise tax                                                              |       | 253                              |       | 234                            |       | 503 |   | 465 |   |
| Write off of issuance cost of Trust  Preferred Securities                       |       | —                           |       | —                         |       | — |   | 229 |   |
| Other expense                                                                   |       | 1,130                            |       | 979                            |       | 2,213 |   | 1,946 |   |
| Total non-interest expense                                                      |       | 6,517                            |       | 5,801                          |       | 12,852 |   | 11,816 |   |
|                                                                            |       |                             |       |                           |       |   |   |   |   |
| Income before income taxes                                                      |       | 3,112                            |       | 3,770                          |       | 5,892 |   | 7,195 |   |
| Income taxes                                                                    |       | 1,013                            |       | 1,226                          |       | 1,910 |   | 2,334 |   |
| **Net Income**                                                                  |       | $                                | 2,099      |                           | $          | 2,544 |   | $ | 3,982 |   | $ | 4,861 |   |
|                                                                            |       |                             |       |                           |       |   |   |   |   |
| (1) Shares applicable to basic income  per share                           |       | 4,664,235                        |       | 4,736,315                      |       | 4,663,784 |   | 4,767,824 |   |
| **(1) Basic income per share**                                             |       | $                                | 0.45       |                           | $          | 0.54 |   | $ | 0.85 |   | $ | 1.02 |   |
|                                                                            |       |                             |       |                           |       |   |   |   |   |
| (1) Shares applicable to diluted  income per share                         |       | 4,692,565                        |       | 4,783,131                      |       | 4,695,358 |   | 4,821,215 |   |
| **(1) Diluted income per share**                                           |       | $                                | 0.45       |                           | $          | 0.53 |   | $ | 0.85 |   | $ | 1.01 |   |
|                                                                            |       |                             |       |                           |       |   |   |   |   |
| **Cash dividends declared per share**                                           |       | $                                | 0.190      |                           | $          | 0.173 |   | $ | 0.380 |   | $ | 0.346 |   |

 

----

**(1)  Adjusted to reflect the impactof the 10% stock dividend declared August 16, 2007.**

 

## ***See notes to the unauditedconsolidated financial statements.***

 

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Comprehensive Income**

**(Unaudited)**

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(Dollars in thousands)**                               | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| **Net Income**                                                     |       | $                                | 2,099      |                           | $          | 2,544 |   | $ | 3,982 |   | $ | 4,861 |   |
| Other comprehensive income (loss):                                 |       |                             |       |                           |       |   |   |   |   |
| Change in unrealized gain (loss) on  securities available-for-sale |       | (569                             | )          | (551                           | )          | (387 | ) | (560 | ) |
| Reclassification of realized amount                                |       | 216                              |       | —                         |       | 216 |   | — |   |
| Net unrealized gain (loss) recognized in comprehensive  income     |       | (353                             | )          | (551                           | )          | (171 | ) | (560 | ) |
| Tax effect                                                         |       | 120                              |       | 187                            |       | 58 |   | 190 |   |
| Total other comphrehensive income (loss)                           |       | (233                             | )          | (364                           | )          | (113 | ) | (370 | ) |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| **Comprehensive Income**                                           |       | $                                | 1,866      |                           | $          | 2,180 |   | $ | 3,869 |   | $ | 4,491 |   |

 

*See notes to the unaudited consolidatedfinancial statements.*

 

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**FIRST FINANCIAL SERVICE CORPORATION**

**Consolidated Statement of Changes inStockholders’ Equity**

**Six Months Ended June 30, 2008**

**(Dollars In Thousands, Except Per ShareAmounts)**

**(Unaudited)**

 
| ** **                                                                            | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **                   | ** ** | **Accumulated**   | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|----------------|------------|------------------------------|------------|-------------------|------------|------------|------------|
| ** **                                                                            | ** ** | ** **            | ** ** | ** **  | ** ** | ** **     | ** ** | ** **                   | ** ** | **Other**         | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional** | ** ** | ** **                   | ** ** | **Comprehensive** | ** ** | ** ** | ** ** |
| ** **                                                                            | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **Retained**   | ** ** | **(Loss), Net of** | ** ** | ** **        | ** ** |
| ** **                                                                            | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**    | ** ** | **Earnings**                 | ** ** | **Tax**           | ** ** | **Total**  | ** ** |
|                                                                                  |       |                  |       |        |       |           |       |                         |       |              |       |       |       |
| **Balance, January 1, 2008**                                                     |       | 4,661                 |       | $           | 4,661      |           | $          | 33,886                       |       | $                 | 35,225     |       | $          | (312 | ) | $ | 73,460 |   |
| Net income                                                                            |       |                  |       |        |       |           |       | 3,982                        |       |              |       | 3,982      |       |
| Stock issued for employee benefit plans                                               |       | 3                     |       | 3           |       | 72             |       |                         |       |              |       | 68         |       |
| Stock-based compensation expense                                                      |       |                  |       |        |       | 60             |       |                         |       |              |       | 67         |       |
| Net change in unrealized gains (losses) on  securities available-for-sale, net of tax |       |                  |       |        |       |           |       |                         |       | (113              | )          | (113       | )          |
| Cash dividends declared ($.38 per share)                                              |       | —                |       | —      |       | —         |       | (1,772                       | )          | —            |       | (1,772     | )          |
| **Balance, June 30, 2008**                                                       |       | 4,664                 |       | $           | 4,664      |           | $          | 34,018                       |       | $                 | 37,435     |       | $          | (425 | ) | $ | 75,692 |   |

 

*See notes to the unaudited consolidatedfinancial statements.*

 

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**FIRSTFINANCIAL SERVICE CORPORATION**

**ConsolidatedStatements of Cash Flows**

**(DollarsIn Thousands)**

**(Unaudited)**

 
| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **June 30,**              | ** ** |
| ** **                                                                         | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| **Operating Activities:**                                                          |       |                           |       |   |   |
| Net income                                                                         |       | $                              | 3,982      |   | $ | 4,861 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities: |       |                           |       |   |   |
| Provision for loan losses                                                          |       | 1,098                          |       | 208 |   |
| Depreciation on premises and equipment                                             |       | 758                            |       | 742 |   |
| Federal Home Loan Bank stock dividends                                             |       | (204                           | )          | — |   |
| Net amortization (accretion)  available-for-sale                                   |       | (2                             | )          | 7 |   |
| Net amortization (accretion)  held-to-maturity                                     |       | 5                              |       | 11 |   |
| Impairment loss on securities                                                      |       | 216                            |       | — |   |
| Gain on sale of real estate held for  development                                  |       | —                         |       | (227 | ) |
| Gain on sale of mortgage loans                                                     |       | (387                           | )          | (292 | ) |
| Origination of loans held for sale                                                 |       | (32,378                        | )          | (17,138 | ) |
| Proceeds on sale of loans held for sale                                            |       | 30,359                         |       | 16,774 |   |
| Stock-based compensation expense                                                   |       | 67                             |       | 52 |   |
| Changes in:                                                                        |       |                           |       |   |   |
| Cash surrender value of life insurance                                             |       | (180                           | )          | (165 | ) |
| Interest receivable                                                                |       | 75                             |       | (268 | ) |
| Other assets                                                                       |       | (388                           | )          | (178 | ) |
| Interest payable                                                                   |       | (734                           | )          | 388 |   |
| Accounts payable and other liabilities                                             |       | (59                            | )          | 480 |   |
| Net cash from operating activities                                                 |       | 2,228                          |       | 5,255 |   |
|                                                                               |       |                           |       |   |   |
| **Investing Activities:**                                                          |       |                           |       |   |   |
| Cash paid for acquisition of Farmers State  Bank, net of cash acquired             |       | (1,466                         | )          | — |   |
| Purchases of securities available-for-sale                                         |       | —                         |       | (395 | ) |
| Maturities of securities available-for-sale                                        |       | 1,639                          |       | 4,697 |   |
| Maturities of securities held-to-maturity                                          |       | 11,906                         |       | 2,445 |   |
| Net change in loans                                                                |       | (27,084                        | )          | (24,281 | ) |
| Net purchases of premises and equipment                                            |       | (2,997                         | )          | (2,318 | ) |
| Sales of real estate for development                                               |       | —                         |       | 473 |   |
| Net cash from investing activities                                                 |       | (18,002                        | )          | (19,379 | ) |
|                                                                               |       |                           |       |   |   |
| **Financing Activities**                                                           |       |                           |       |   |   |
| Net change in deposits                                                             |       | 40,092                         |       | 43,416 |   |
| Change in short-term borrowings                                                    |       | (9,800                         | )          | (28,000 | ) |
| Repayments to Federal Home Loan Bank                                               |       | (68                            | )          | (72 | ) |
| Proceeds from issuance of subordinated  debentures                                 |       | 8,000                          |       | 10,000 |   |
| Payoff of subordinated debentures                                                  |       | —                         |       | (10,000 | ) |
| Issuance of common stock for employee  benefit plans                               |       | 68                             |       | 104 |   |
| Dividends paid                                                                     |       | (1,772                         | )          | (1,643 | ) |
| Common stock repurchased                                                           |       | —                         |       | (3,186 | ) |
| Net cash from financing activities                                                 |       | 36,520                         |       | 10,619 |   |
|                                                                               |       |                           |       |   |   |
| **(Decrease) Increase in cash and cash  equivalents**                              |       | 20,746                         |       | (3,505 | ) |
| **Cash and cash equivalents, beginning of  period**                                |       | 14,948                         |       | 19,082 |   |
| **Cash and cash equivalents, end of period**                                       |       | $                              | 35,694     |   | $ | 15,577 |   |

 

*See notes to the unaudited consolidatedfinancial statements.*

* *

*See Note 7 regarding non-cash transactionsincluded in the acquisition.*

 

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**NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.****                                     ****BASIS OF PRESENTATION ANDSUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

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

 

Theaccompanying unaudited consolidated financial statements have been prepared inaccordance with U.S. generally accepted accounting principles for interimfinancial information and with the instructions to Form 10-Q and Rule 10-01of Regulation S-X.  Accordingly, they donot include all of the information and footnotes required by U.S. generallyaccepted accounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the three and six month periods ending June 30,2008 are not necessarily indicative of the results that may occur for the yearending December 31, 2008.  Forfurther information, refer to the consolidated financial statements andfootnotes thereto included in the Corporation’s annual report on Form 10-Kfor the period ended December 31, 2007.

 

***Stock Dividend***– We declared a 10% stock dividend on August 16,2007 to our shareholders of record as of August 29, 2007, payable on September 14,2007.  The payment of this dividend wasin addition to the regular quarterly cash dividend.  Per share amounts have been restated for theimpact of the stock dividend.

 

Stockdividends for 20% or less are reported by transferring the fair value, as ofthe dividend date, of the stock issued from retained earnings to common stockand additional paid-in-capital. Fractional share amounts are paid in cash with a reduction to retainedearnings.

 

***Adoption of New Accounting Standards***– We adopted theprovisions of SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”) on January 1,2008.  SFAS No. 157 defines fairvalue, establishes a framework for measuring fair value in U.S. generallyaccepted accounting principles (U.S. GAAP), and expands disclosures about fairvalue measurements.  More specifically,this statement clarifies the definition of fair value, establishes a fairvaluation hierarchy based upon observable (e.g. quoted prices, interest rates,yield curves) and unobservable market inputs, and expands disclosurerequirements to include the inputs used to develop estimates of fair value andthe effects of the estimates on income for the period. This statement does notrequire any new fair value measurements. For further information, see Note 6.

 

InFebruary 2008, the FASB issued Staff Position (FSP) 157-2, Effective Dateof FASB Statement  No. 157.  This FSP delays the effective date of FAS 157  for all nonfinancial assets and nonfinancialliabilities, except those that  are  recognized or  disclosed at fair value on arecurring basis (at least  annually)  to fiscal  years  beginning after November 15, 2008, andinterim periods within those fiscal years.

 

InFebruary 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial Assets and Financial Liabilities —Including an amendment of FASB Statement No. 115.”****This statement allows companies to recordcertain financial assets and financial liabilities at full fair value if theyso choose. The statement was issued to mitigate volatility in reported earningscaused by an accounting model utilizing multiple measurement attributes. Theadoption of the fair value option is recorded as a cumulative-effect adjustmentto the opening balance of retained earnings, which would be January 1,2008. Upon adoption, the difference between the carrying amount and the fairvalue of the items chosen is removed from the balance sheet and included in thecumulative-effect adjustment. Subsequent changes in fair value are recordedthrough the income statement. We did not elect the fair value option for anyfinancial assets or financial liabilities as of January 1, 2008 orsubsequently.

 

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

 

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

 

***RecentAccounting Pronouncements***– In December 2007, the FASB issued SFAS 141 (revised 2007), *Business Combinations*(*SFAS 141R*). SFAS 141R establishesprinciples and requirements for how the acquirer of a business recognizes andmeasures in its financial statements the identifiable assets acquired, theliabilities assumed, and any non-controlling interest in the acquiree. SFAS141R also provides guidance for recognizing and measuring the goodwill acquiredin the business combination and determines what information to disclose toenable users of the financial statements to evaluate the nature and financial effectsof the business combination. SFAS 141R is effective for business combinationswhere the acquisition date is on or after fiscal years beginning after December 15,2008. SFAS******141R isexpected to have an impact on our accounting for any business combinationsclosing on or after January 1, 2009.

 

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

 

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

 

**2.**                                      **SECURITIES**

 

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

 
| ** **                           | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** **          | ** ** |
|--------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|---------------------|------------|
| ** **                           | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
| **(Dollars in thousands)** | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Fair Value** | ** ** |
| **Securities available-for-sale:**   |       |          |       |           |       |           |       |                |       |
| **June 30, 2008:**              |       |          |       |           |       |           |       |                |       |
| Mortgage-backed                      |       | $             | 6,765      |           | $          | 14             |       | $                   | (67        | ) | $ | 6,712 |   |
| Equity                               |       | 1,336         |       | 165            |       | (13            | )          | 1,488               |       |
| State and municipal                  |       | 9,786         |       | 4              |       | (746           | )          | 9,044               |       |
| Corporate                            |       | 2,736         |       | —         |       | —         |       | 2,736               |       |
|                                 |       |          |       |           |       |           |       |                |       |
| Total                                |       | $             | 20,623     |           | $          | 183            |       | $                   | (826       | ) | $ | 19,980 |   |
|                                 |       |          |       |           |       |           |       |                |       |
| **December 31, 2007:**          |       |          |       |           |       |           |       |                |       |
| U.S. Treasury and agencies           |       | $             | 498        |           | $          | 3              |       | $                   | —     |   | $ | 501 |   |
| Mortgage-backed                      |       | 7,624         |       | 5              |       | (53            | )          | 7,576               |       |
| Equity                               |       | 1,553         |       | 324            |       | (355           | )          | 1,522               |       |
| State and municipal                  |       | 9,994         |       | 4              |       | (400           | )          | 9,598               |       |
| Corporate                            |       | 2,807         |       | —         |       | —         |       | 2,807               |       |
|                                 |       |          |       |           |       |           |       |                |       |
| Total                                |       | $             | 22,476     |           | $          | 336            |       | $                   | (808       | ) | $ | 22,004 |   |

 
| ** **                       | ** ** | ** **    | ** ** | **Gross**        | ** ** | **Gross**        | ** ** | ** **          | ** ** |
|----------------------------------|------------|---------------|------------|------------------|------------|------------------|------------|---------------------|------------|
| ** **                       | ** ** | **Amortized** | ** ** | **Unrecognized** | ** ** | **Unrecognized** | ** ** | ** **          | ** ** |
| ** **                       | ** ** | **Cost**      | ** ** | **Gains**        | ** ** | **Losses**       | ** ** | **Fair Value** | ** ** |
| **Securities held-to-maturity:** |       |          |       |             |       |             |       |                |       |
| **June 30, 2008:**          |       |          |       |             |       |             |       |                |       |
| U.S. Treasury and agencies       |       | $             | 5,518      |             | $          | 63               |       | $                   | —     |   | $ | 5,581 |   |
| Mortgage-backed                  |       | 1,999         |       | —           |       | (9               | )          | 1,990               |       |
| State and municipal              |       | 487           |       | —           |       | —           |       | 487                 |       |
| Corporate                        |       | 279           |       | —           |       | (29              | )          | 250                 |       |
|                             |       |          |       |             |       |             |       |                |       |
| Total                            |       | $             | 8,283      |             | $          | 63               |       | $                   | (38        | ) | $ | 8,308 |   |
|                             |       |          |       |             |       |             |       |                |       |
| **December 31, 2007:**      |       |          |       |             |       |             |       |                |       |
| U.S. Treasury and agencies       |       | $             | 14,098     |             | $          | 33               |       | $                   | (38        | ) | $ | 14,093 |   |
| Mortgage-backed                  |       | 3,142         |       | 1                |       | (51              | )          | 3,092               |       |
| Corporate                        |       | 441           |       | —           |       | (2               | )          | 439                 |       |
|                             |       |          |       |             |       |             |       |                |       |
| Total                            |       | $             | 17,681     |             | $          | 34               |       | $                   | (91        | ) | $ | 17,624 |   |

 

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

 

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

 

Loans are summarized as follows:

 
| ** **                           | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**          | ** ** | **2007**              | ** ** |
|                                 |       |              |       |                  |       |
| Commercial                           |       | $                 | 52,412     |                  | $          | 52,595 |   |
| Real estate commercial               |       | 512,521           |       | 470,929               |       |
| Real estate construction             |       | 19,241            |       | 21,383                |       |
| Residential mortgage                 |       | 165,978           |       | 132,329               |       |
| Consumer and home equity             |       | 65,071            |       | 63,090                |       |
| Indirect consumer                    |       | 26,853            |       | 27,721                |       |
| Loans held for sale                  |       | 3,186             |       | 780                   |       |
|                                 |       | 845,262           |       | 768,827               |       |
| Less:                                | ** ** | ** **        | ** ** | ** **            | ** ** |
| Net deferred loan origination fees   |       | (720              | )          | (791                  | )          |
| Allowance for loan losses            |       | (8,917            | )          | (7,922                | )          |
|                                 |       | (9,637            | )          | (8,713                | )          |
| ** **                           | ** ** | ** **        | ** ** | ** **            | ** ** |
| Loans                                |       | $                 | 835,625    |                  | $          | 760,114 |   |

 

The allowance for loan loss is summarized as follows:

 
| ** **                           | ** ** | **As of and For the** | ** ** | **As of and For the** | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                           | ** ** | **Three Months Ended**          | ** ** | **Six Months Ended**            | ** ** |
| ** **                           | ** ** | **June 30,**                         | ** ** | **June 30,**                         | ** ** |
| **(Dollars in thousands)** | ** ** | **2008**                                  | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                 |       |                                      |       |                                      |       |   |   |   |   |
| Balance, beginning of period         |       | $                                         | 8,395      |                                      | $          | 7,730 |   | $ | 7,922 |   | $ | 7,684 |   |
| Allowance related to acquisition     |       | 327                                       |       | —                                    |       | 327 |   | — |   |
| Provision for loan losses            |       | 514                                       |       | 127                                       |       | 1,098 |   | 208 |   |
| Charge-offs                          |       | (425                                      | )          | (95                                       | )          | (574 | ) | (201 | ) |
| Recoveries                           |       | 106                                       |       | 60                                        |       | 144 |   | 131 |   |
| Balance, end of period               |       | $                                         | 8,917      |                                      | $          | 7,822 |   | $ | 8,917 |   | $ | 7,822 |   |

 

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

 
| ** **                                  | ** ** | **As of and For the** | ** ** | **As of and For the** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | **Six Months Ended**            | ** ** | **Year Ended**                       | ** ** |
| ** **                                  | ** ** | **June 30,**                         | ** ** | **December 31,**                     | ** ** |
| **(Dollars in thousands)**        | ** ** | **2008**                                  | ** ** | **2007**                                  | ** ** |
|                                        |       |                                      |       |                                      |       |
| End of period impaired loans                |       | $                                         | 15,213     |                                      | $          | 8,889 |   |
| Amount of allowance for loan loss allocated |       | 591                                       |       | 117                                       |       |
|                                             |            |                                           |            |                                           |            |  |  |

 

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

 

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

 

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

 
| ** **                                    | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(Dollars in thousands)**          | ** ** | **2008**          | ** ** | **2007**              | ** ** |
|                                          |       |              |       |                  |       |
| Restructured                                  |       | $                 | 861        |                  | $          | 2,335 |   |
| Loans past due over 90 days still on  accrual |       | —            |       | —                |       |
| Non accrual loans                             |       | 14,352            |       | 6,554                 |       |
| Total                                         |       | $                 | 15,213     |                  | $          | 8,889 |   |

 

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

 

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

 
| ** **                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| **(Dollars in thousands,**           | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **except per share data)**      | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                           |       |                             |       |                           |       |   |   |   |   |
| Net income available to common shareholders    |       | $                                | 2,099      |                           | $          | 2,544 |   | $ | 3,982 |   | $ | 4,861 |   |
| Basic EPS:                                     |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares                 |       | 4,664                            |       | 4,736                          |       | 4,664 |   | 4,768 |   |
| Diluted EPS:                                   |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares                 |       | 4,664                            |       | 4,736                          |       | 4,664 |   | 4,768 |   |
| Dilutive effect of stock options               |       | 28                               |       | 47                             |       | 31 |   | 53 |   |
| Weighted average common and incremental shares |       | 4,692                            |       | 4,783                          |       | 4,695 |   | 4,821 |   |
| Earnings Per Share:                            |       |                             |       |                           |       |   |   |   |   |
| Basic                                          |       | $                                | 0.45       |                           | $          | 0.54 |   | $ | 0.85 |   | $ | 1.02 |   |
| Diluted                                        |       | $                                | 0.45       |                           | $          | 0.53 |   | $ | 0.85 |   | $ | 1.01 |   |

 

Stock options for 55,050 and 28,600 shares of commonstock were not included in the June 30, 2008 and 2007 computation ofdiluted earnings per share for both the quarter and year to date because theirimpact was anti-dilutive.

 

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

 

Our2006 Stock Incentive Plan, which is shareholder approved, succeeded our 1998Stock Option and Incentive Plan.  Underthe 2006 Plan, we may grant either incentive or non-qualified stock options to****key employees and directors****for a total of 642,350 shares of ourcommon stock at not less than fair value at the date such options are granted.** **Optionsavailable for future grant under the 1998 Plan totaled 38,500 shares and wererolled into the 2006 Plan.** **We believe that the ability toaward stock options and other forms of stock-based incentive compensation canassist us in attracting and retaining key employees. Stock-based incentivecompensation 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 vestover periods of one to five years and expire ten years after the date of grant.** **Weissue new shares of common stock upon the exercise of stock options. ** **At June 30,2008 options available for future grant under the 2006 Plan totaled 591,750.** **Compensationcost related to options granted under the 1998 and 2006 Plans that was chargedagainst earnings for the six month periods ended June 30, 2008****and 2007 was $60,000 and $52,000.

 

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

 

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

 

Thefair value of each option award is estimated on the date of grant using theBlack-Scholes option valuation model that uses various weighted-averageassumptions.  The risk-free interest rateis based on the U.S. Treasury yield curve in effect at the time of grant.  The expected volatility is based on thefluctuation in the price of a share of stock over the period for which theoption is being valued and the expected life of the options granted representsthe period of time the options are expected to be outstanding.

 

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

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

 

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

 
| ** **                          | ** ** | ** **  | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **      | ** ** |
|-------------------------------------|------------|-------------|------------|--------------|------------|-----------------|------------|-----------------|------------|
| ** **                          | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **      | ** ** |
| ** **                          | ** ** | **Number**  | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate**   | ** ** |
| ** **                          | ** ** | **of**      | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic**   | ** ** |
| ** **                          | ** ** | **Options** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**       | ** ** |
| ** **                          | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | **(Dollars In** | ** ** |
| ** **                          | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | **Thousands)**  | ** ** |
| Outstanding, beginning of period    |       | 193,067     |       | $            | 18.95      | ** **      | ** ** | ** **      | ** ** | ** ** |
| Granted during period               |       | 15,000      |       | 23.14        | ** ** | ** **      | ** ** | ** **      | ** ** |
| Forfeited during period             |       | (550        | )          | 28.00        | ** ** | ** **      | ** ** | ** **      | ** ** |
| Exercised during the period         |       | —      |       | —       | ** ** | ** **      | ** ** | ** **      | ** ** |
| Outstanding, end of period          |       | 207,517     |       | $            | 19.23      |            | 5.4        |            | $          | — |   |
| ** **                          | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | ** **      | ** ** |
| Eligible for exercise at period end |       | 128,086     |       | $            | 17.09      |            | 3.8        |            | $          | 135 |   |

 

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

 

Asof June 30, 2008 there was $316,000 of total unrecognized compensationcost related to non-vested share-based compensation arrangements granted underthe 1998 and 2006 Plans.  That cost isexpected to be recognized over a weighted-average period of 3.6 years.  Cash received from option exercises under allshare-based payment arrangements for the periods ended June 30, 2008 and2007 was $0 and $72,000.

 

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

 

**6.****                                     ****FAIR VALUE**

 

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

 

**Level 1:**Quoted prices (unadjusted) for identical assets or liabilities in activemarkets.  A quoted price in an activemarket provides the most reliable evidence of fair value and shall be used tomeasure fair value whenever available.

 

**Level 2:**Significantother observable inputs other than Level 1 prices such as quoted prices forsimilar assets or liabilities; quoted prices in markets that are not active; orother inputs that are observable or can be corroborated by observable marketdata.

 

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

 

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

 

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

 
| ** **                           | ** ** | ** **        | ** ** | **Quoted Prices in**   | ** ** | ** **                 | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|-------------------|------------|----------------------------------|------------|----------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | ** **        | ** ** | **Active Markets for** | ** ** | **Significant Other** | ** ** | **Significant**              | ** ** |
| ** **                           | ** ** | **June 30,** | ** ** | **Identical Assets**        | ** ** | **Observable Inputs** | ** ** | **Unobservable Inputs** | ** ** |
| **(Dollars in thousands)** | ** ** | **2008**          | ** ** | **(Level 1)**               | ** ** | **(Level 2)**         | ** ** | **(Level 3)**           | ** ** |
|                                 |       |              |       |                             |       |                       |       |                         |       |
| Assets:                              | ** ** | ** **        | ** ** | ** **                       | ** ** | ** **                 | ** ** | ** **                   | ** ** |
| Available-for-sale securities        |       | $                 | 19,980     |                             | $          | 1,488                      |       | $                            | 17,970     |   | $ | 522 |   |
|                                      |            |                   |            |                                  |            |                            |            |                              |            |  |  |  |  |

 

Thefair values of equity securities are determined by obtaining quoted prices onnationally recognized securities exchanges (Level 1 inputs).  The fair values of debt securities aredetermined by a matrix pricing, which is a mathematical technique widely usedin the industry to value debt securities without relying exclusively on quotedprices for the specific securities but rather by relying on the securities’relationship to other benchmark quoted securities (Level 2 inputs).  In certain cases where there is limitedactivity or less transparency around inputs to the valuation, securities areclassified within (Level 3) of the valuation hierarchy.  Equity securities that do not have a readilydeterminable fair value are carried at cost and are evaluated for impairment ona periodic basis.

 

Weconduct a thorough review of fair value hierarchy classifications on a quarterlybasis.  Reclassification of certainfinancial instruments may occur when input observability changes.

 

The table below presents a reconciliation and income statementclassification of gains and losses for all assets measured at fair value on arecurring basis using significant unobservable inputs (Level 3) for the periodended June 30, 2008:

 
| ** **                         | ** ** | **Fair Value**          | ** ** |
|------------------------------------|------------|-------------------------|------------|
| ** **                         | ** ** | **Measurements**        | ** ** |
| ** **                         | ** ** | **Using Significant**   | ** ** |
| ** **                         | ** ** | **Unobservable Inputs** | ** ** |
| ** **                         | ** ** | **(Level 3)**           | ** ** |
| **(Dollars  in thousands)**        | ** ** | **Asset/Liability**     | ** ** |
|                               |       |                    |       |
| Beginning balance, January 1, 2008 |       | $                       | —     |   |
| Total gains or losses realized:    |       |                    |       |
| Included in earnings               |       |                    |       |
| Impairment charge on security      |       | (118                    | )          |
| Transfers in and/or out of Level 3 |       | 640                     |       |
| Ending balance, June 30, 2008      |       | $                       | 522        |   |

 

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

 

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

 
| ** **                           | ** ** | ** **        | ** ** | **Quoted Prices in**   | ** ** | ** **                 | ** ** | ** **                   | ** ** |
|--------------------------------------|------------|-------------------|------------|----------------------------------|------------|----------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | ** **        | ** ** | **Active Markets for** | ** ** | **Significant Other** | ** ** | **Significant**              | ** ** |
| ** **                           | ** ** | **June 30,** | ** ** | **Identical Assets**        | ** ** | **Observable Inputs** | ** ** | **Unobservable Inputs** | ** ** |
| **(Dollars in thousands)** | ** ** | **2008**          | ** ** | **(Level 1)**               | ** ** | **(Level 2)**         | ** ** | **(Level 3)**           | ** ** |
|                                 |       |              |       |                             |       |                       |       |                         |       |
| Assets:                              | ** ** | ** **        | ** ** | ** **                       | ** ** | ** **                 | ** ** | ** **                   | ** ** |
| Impaired Loans                       |       | $                 | 14,622     |                             | $          | —                     |       | $                            | —     |   | $ | 14,622 |   |
|                                      |            |                   |            |                                  |            |                            |            |                              |            |  |  |  |  |

 

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

 

**6.****                                     ****FAIR VALUE****- (Continued)**

 

Impaired loans, which are measured for impairmentusing the fair value of the collateral for collateral dependent loans, had acarrying amount of $15.2 million, with a valuation allowance of $591,000,resulting in an additional provision for loan losses of $474,000 for the 2008 sixmonth period.  Values for collateraldependent loans are generally based on appraisals obtained from licensed realestate appraisals and in certain circumstances consideration of offers obtainedto purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods toderive value: cost, sales or market comparison and income approach.  The cost method bases value on the estimated costto replace the current property after considering adjustments for depreciation.  Values of the market comparison approachevaluate the sales price of similar properties in the same market area.  The income approach considers net operatingincome generated by the property and an investors required return.  The final value is a reconciliation of thesethree approaches and takes into consideration any other factors managementdeems relevant to arrive at a representative fair value.

 

**7.****                                     ****BUSINESS COMBINATION**

 

On June 25, 2008, weacquired 100% of the outstanding shares of FSB Bancshares, Inc. and itswholly owned subsidiary, The Farmers State Bank, located in Southern Indiana.  The Farmers State Bank has offices inHarrison and Floyd County, Indiana. These counties are adjacent to our counties of Meade, Hardin, Bullittand Jefferson.  The branches of The Farmers State Bank arebranches of First Financial Service Corporation’s wholly owned subsidiary FirstFederal Savings Bank.  Operating resultsof FSB Bancshares, Inc. have been included in the consolidated financialstatements since the date of the acquisition. The purpose of the acquisition was to establish market share in thestate of Indiana, expand our customer base, enhance deposit fee income andprovide an opportunity to market additional products and services to newcustomers.

 

Theaggregate purchase price was $14.0 million, paid in cash. The purchase priceresulted in approximately $3.9 million in goodwill and $1.9 million in coredeposit intangibles.  The core depositintangible asset is being amortized over 8.5 years, using the straight-linemethod.  Goodwill will not be amortizedbut instead evaluated periodically for impairment.  Goodwill and intangible assets are notdeducted for tax purposes. As of the date of this report, we were in theprocess of obtaining third party valuations and completing fair value estimatesfor certain assets and liabilities. Therefore, the allocation of the purchase price is subject torefinement.

 

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

 
| **(Dollars in thousands)**     | ** ** | **Amount** | ** ** |
|------------------------------------------|------------|------------|------------|
| Cash                                     |       | $          | 12,534     |   |
| Securities held to maturity              |       | 2,512      |       |
| Loans, net                               |       | 48,645     |       |
| FHLB Stock                               |       | 585        |       |
| Premises and equipment                   |       | 872        |       |
| Real estate acquired through foreclosure |       | 185        |       |
| Goodwill                                 |       | 3,878      |       |
| Core deposit intangibles                 |       | 1,910      |       |
| Other assets                             |       | 250        |       |
| Total assets acquired                    |       | 71,371     |       |
|                                     |       |       |       |
| Deposits                                 |       | 55,751     |       |
| Other liabilities                        |       | 1,620      |       |
| Total liabilities assumed                |       | 57,371     |       |
|                                     |       |       |       |
| Net assets acquired                      |       | $          | 14,000     |   |

 

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

 

**7.****                                     ****BUSINESS COMBINATION****- (Continued)**

 

**Pro Forma Results of Operations**

 

The following tablepresents unaudited pro forma results of operations for the three and six monthsended June 30, 2008 and 2007, as if the Farmers State Bank acquisition hadoccurred effective January 1, 2007. The pro forma financial information isnot necessarily indicative of the results of operations as they actually wouldhave been if the acquisition had occurred at January 1, 2007, and is notintended to be a projection of future results.

 
| **(Dollars in thousands, except  per share data)** | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                         | ** ** | **2008**                              | ** ** | **2007**                            | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net interest  income                               |       | $                                     | 8,584      |                                | $          | 8,356 |   | $ | 16,964 |   | $ | 16,633 |   |
| Net income                                         |       | 1,629                                 |       | 2,723                               |       | 3,619 |   | 5,202 |   |
| Basic income  per share                            |       | $                                     | 0.35       |                                | $          | 0.57 |   | $ | 0.78 |   | $ | 1.09 |   |
| Diluted  income per share                          |       | 0.35                                  |       | 0.57                                |       | 0.77 |   | 1.08 |   |

 

**8.****                                     ****SUBORDINATED DEBENTURES**

 

OnJune 24, 2008, First Federal Statutory Trust III, an unconsolidated trustsubsidiary of First Financial Service Corporation, issued $8.0 million in trustpreferred securities.  The trust loanedthe proceeds of the offering to us in exchange for junior subordinateddeferrable interest debentures which we used to finance the purchase of FSBBancshares, Inc.  In accordance withFASB Interpretation 46, the trust is not consolidated with our financialstatements but rather the subordinated debentures are shown as aliability.  The subordinated debentures,which mature on June 24, 2038, can be called at par in whole or in part onor after June 24, 2018. The subordinated debentures pay a fixed rate of 8%for thirty years.  We have the option todefer interest payments on the subordinated debt from time to time for a periodnot to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for theCorporation under current regulatory guidelines.

 

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**Item 2.**

 

## **MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION**

**AND RESULTSOF OPERATIONS**

 

##### **GENERAL**

##### ** **

Weconduct operations in 19 full-service banking centers and a commercial privatebanking center in six contiguous counties in Central Kentucky along theInterstate 65 corridor and two contiguous counties in Southern Indiana.  Our markets range from the major metropolitanarea of Louisville in Jefferson County, Kentucky approximately 40 miles northof our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky,approximately 30 miles south of Elizabethtown to Harrison County, Indianaapproximately 60 miles northwest of our headquarters.  Our markets are supported by a diversified industrybase and have a regional population of over 1 million.

 

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

 

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

 

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

 

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

 

**OVERVIEW**

 

Duringthe second quarter, we completed the acquisition of FSB Bancshares, Inc.and its wholly owned subsidiary, The Farmers State Bank, located in SouthernIndiana.  The Farmers State Bank hadapproximately $65.6 million in total assets and $55.8 million in deposits withoffices in Harrison and Floyd County, Indiana. These counties are adjacent to our Kentucky counties of Meade, Hardin,Bullitt and Jefferson and are part of the Louisville MSA.  The branches of The Farmers State Bank arebranches of First Financial Service Corporation’s wholly owned subsidiary FirstFederal Savings Bank.  The acquisition isanticipated to be accretive to our earnings during the first full year of thecombined operations.

 

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

 

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Ourretail branch network continues to generate encouraging results.  Total deposits have grown 31% over the pastthree years.  Total deposits were $785.1 millionat June 30, 2008, an increase of $95.8 million from December 31,2007.  The continued development of theretail branch network into the Louisville market also yielded positiveresults.  We have a combined $56.5million in deposits in our three full-service facilities in the Louisvillemarket.  We opened two of thesefacilities in the second quarter of 2004 to support our growing customer basein this market. In June 2007 we opened our third new full service bankingcenter in Louisville.  Additional siteswithin the Louisville market are under development with our fourth locationscheduled to open in the second quarter of 2009.Competition for deposits continues to bechallenging in all of the markets we serve. This intense competition could add to additional margin compression asthe interest rate environment stabilizes over the second half of the year.

 

Wehave developed a strong commercial real estate niche in our markets.  We have an experienced team of bankers whoare focused on providing service and convenience to our customers.  It is quite common for our bankers to closeloans at a customer’s place of business or even the customer’s personalresidence. This high level of service has been especially well received in ourLouisville market, which is dominated by regional banks.  Currently, 25% of our loan portfolio residesin the Louisville market.  To furtherdevelop our commercial banking relationships in Louisville, we opened a privatebanking office in April 2007.  Thisoffice is an upscale facility complementing our retail branch network inLouisville allowing us to further attract commercial deposit relationships inconjunction with our commercial lending relationships.

 

Thisemphasis on commercial lending generated 38% growth in the total loan portfolioand 62% growth in commercial loans over the past three years.  Commercial loans were $584.2 million at June 30,2008, an increase of $39.3 million, or 7% from December 31, 2007.

 

###### **CRITICALACCOUNTING POLICIES**

###### ** **

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

 

***Allowance for Loan Losses*****–**We maintain an allowance sufficient to absorbprobable incurred credit losses existing in the loan portfolio. The Allowancefor Loan Loss Review Committee evaluates the allowance for loan losses on aquarterly basis.  We estimate the allowance using past loan loss experience,known and inherent risks in the portfolio, adverse situations that may affectthe borrower’s ability to repay, estimated value of the underlying collateral,and current economic conditions.  While we estimate the allowance for loanlosses based in part on historical losses within each loan category, estimatesfor losses within the commercial real estate portfolio are more dependent uponcredit analysis and recent payment performance. Allocations of theallowance may be made for specific loans or loan categories, but the entireallowance is available for any loan that, in management’s judgment, should becharged off.

 

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

 

Basedon our calculation, an allowance of $8.9 million****or 1.06% of total loans was our estimate of probable losseswithin the loan portfolio as of****June 30,2008.** **This estimate resultedin a provision for loan losses on the income statement of****$1.1 million for the 2008 six monthperiod.** **If the mix andamount of future charge off percentages differ significantly from thoseassumptions used by management in making its determination, the allowance forloan losses and provision for loan losses on the income statement could bematerially increased.

 

***Stock-based Compensation*****–**We adopted theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R) “Share-Based Payment (Revised 2004),” on January 1, 2006.  Among other things, SFAS No. 123 (R) eliminatesthe ability to account for stock-based compensation using the intrinsic valuebased method of accounting and requires that such transactions be recognized ascompensation expense in the income statement based on their fair values on thedate of the grant.  SFAS No. 123 (R)requires that management make assumptions including stock price volatility andemployee turnover that are utilized to measure compensation

 

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expense.  Weestimate fair value of stock options granted at the date of grant using theBlack-Scholes option pricing model, which requires the input of highlysubjective assumptions, such as volatility, risk free interest rates anddividend pay out rates.

 

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

 

Net income for the quarter ended June 30, 2008was $2.1 million or $0.45 per share diluted compared to $2.5 million or $0.53per share diluted for the same period in 2007. ** **Net income for the six month period ended June 30, 2008 was $4.0 millionor $.85 per share diluted compared to $4.9 million or $1.01 per share dilutedfor the same period a year ago.  Earningsdecreased for 2008 compared to 2007 due to a decrease in our net interestmargin, an increase in provision for loan loss expense, a higher level ofnon-interest expense related to our expansion efforts and a write down taken oninvestment securities that were other-than-temporarily impaired.  ** **Our book value per commonshare increased from $15.27 at June 30, 2007 to $16.23 at June 30, 2008.** **Annualizednet income for the first six months of 2008 generated a return on averageassets of .90% and a return on average equity of 10.65%.** **Thesecompare with a return on average assets of 1.17% and a return on average equityof 13.55% for the first six months of 2007 also annualized.

 

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

 

Thegrowth in our commercial loan portfolio has increased interest income.  The increase in the volume of interestearning assets increased net interest income by $344,000 and $513,000 for thethree and six month 2008 periods compared to the same periods a year ago.  Average interest earning assets increased$47.6 million for the 2008 quarter and $42.4 million for the six monthscompared to 2007.  Despite the increasein interest earning assets, our net interest margin declined.  The yield on earning assets averaged 6.66%and 6.90% for the three and six month 2008 periods compared to an average yieldon earning assets of 7.67% and  7.66% forthe same periods in 2007.  This decreasewas slightly offset by a decrease in our cost of funds.  On an annualized basis, the net interestmargin as a percent of average earning assets decreased****5 basis points to 3.88% for the quarterended June 30, 2008 and 9 basis points to 3.86% for the six months ended June 30,2008 compared to 3.93% and 3.95% for the same periods in 2007.

 

Ourcost of funds averaged 3.04% and 3.35% for the quarter and six month periodsended June 30, 2008 compared to an average cost of funds of 4.11% and4.07% for the same periods in 2007.  In March 2007,we refinanced $10.0 million in subordinated debentures.  Refinancing at a lower rate reduced interestexpense by $48,000 for the 2008 six month period.  Going forward, our cost of funds is expectedto continue to decrease as certificates of deposit re-price and roll off intonew certificates of deposit at lower interest rates.

 

20

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**AVERAGE BALANCE SHEET**

 

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

 
| ** **                                          | ** ** | **Quarter Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          | ** ** | **2008**                                  | ** ** | **2007** | ** ** |
| ** **                                          | ** ** | **Average**                               | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)**                | ** ** | **Balance**                               | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** |
|                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                          |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets:                            |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies                          |       | $                                         | 4,763      |   | $ | 54 |   | 4.56 | % | $ | 20,009 |   | $ | 185 |   | 3.71 | % |
| Mortgage-backed securities                          |       | 9,182                                     |       | 97 |   | 4.25 |   | 12,393 |   | 134 |   | 4.34 |   |
| Equity securities                                   |       | 1,659                                     |       | 16 |   | 3.88 |   | 2,055 |   | 18 |   | 3.51 |   |
| State and political subdivision securities **(1)**  |       | 9,494                                     |       | 159 |   | 6.74 |   | 10,353 |   | 163 |   | 6.31 |   |
| Corporate bonds                                     |       | 3,076                                     |       | 27 |   | 3.53 |   | 5,025 |   | 62 |   | 4.95 |   |
| Loans **(2) (3) (4)**                     |       | 797,436                                   |       | 13,348 |   | 6.73 |   | 729,017 |   | 14,364 |   | 7.90 |   |
| FHLB stock                                          |       | 7,917                                     |       | 104 |   | 5.28 |   | 7,621 |   | 123 |   | 6.47 |   |
| Interest bearing deposits                           |       | 1,345                                     |       | 12 |   | 3.59 |   | 787 |   | 14 |   | 7.14 |   |
| **Total interest earning assets**                   |       | 834,872                                   |       | 13,817 |   | 6.66 |   | 787,260 |   | 15,063 |   | 7.67 |   |
| Less: Allowance for loan losses                     |       | (8,522                                    | )          |   |   |   |   | (7,699 | ) |   |   |   |   |
| Non-interest earning assets                         |       | 76,539                                    |       |   |   |   |   | 59,909 |   |   |   |   |   |
| **Total assets**                                    |       | $                                         | 902,889    |   |   |   |   |   | $ | 839,470 |   |   |   |   |   |
|                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                       |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                    |       | $                                         | 107,954    |   | $ | 436 |   | 1.62 | % | $ | 100,564 |   | $ | 825 |   | 3.29 | % |
| NOW and money market accounts                       |       | 136,268                                   |       | 321 |   | 0.95 |   | 118,851 |   | 490 |   | 1.65 |   |
| Certificates of deposit and other time deposits     |       | 417,577                                   |       | 4,051 |   | 3.90 |   | 427,917 |   | 5,126 |   | 4.80 |   |
| Short term borrowings                               |       | 34,371                                    |       | 183 |   | 2.14 |   | 27,992 |   | 413 |   | 5.92 |   |
| FHLB advances                                       |       | 53,026                                    |       | 601 |   | 4.56 |   | 31,473 |   | 340 |   | 4.33 |   |
| Subordinated debentures                             |       | 12,667                                    |       | 167 |   | 5.30 |   | 10,000 |   | 154 |   | 6.18 |   |
| **Total interest bearing liabilities**              |       | 761,863                                   |       | 5,759 |   | 3.04 |   | 716,797 |   | 7,348 |   | 4.11 |   |
| Non-interest bearing liabilities:                   |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing deposits                       |       | 59,600                                    |       |   |   |   |   | 44,884 |   |   |   |   |   |
| Other liabilities                                   |       | 5,589                                     |       |   |   |   |   | 5,396 |   |   |   |   |   |
| **Total liabilities**                               |       | 827,052                                   |       |   |   |   |   | 767,077 |   |   |   |   |   |
|                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                           |       | 75,837                                    |       |   |   |   |   | 72,393 |   |   |   |   |   |
| **Total liabilities and stockholders’ equity** |       | $                                         | 902,889    |   |   |   |   |   | $ | 839,470 |   |   |   |   |   |
|                                                |       |                                      |       |   |   |   |   |   |   |   |   |   |   |
| **Net interest income**                             |       |                                      |       | $ | 8,058 |   |   |   |   |   | $ | 7,715 |   |   |   |
| **Net interest spread**                             |       |                                      |       |   |   | 3.62 | % |   |   |   |   | 3.56 | % |
| **Net interest margin**                             |       |                                      |       |   |   | 3.88 | % |   |   |   |   | 3.93 | % |

 

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| **(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                                                                                                |

 

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| ** **                                          | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                          | ** ** | **2008**                                          | ** ** | **2007** | ** ** |
| ** **                                          | ** ** | **Average**                                       | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | ** ** | ** ** | **Average** | ** ** |
| **(Dollars in thousands)**                | ** ** | **Balance**                                       | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Yield/Cost (5)** | ** ** |
|                                                |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| **ASSETS**                                          |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Interest earning assets:                            |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies                          |       | $                                                 | 8,023      |   | $ | 160 |   | 4.01 | % | $ | 20,587 |   | $ | 373 |   | 3.65 | % |
| Mortgage-backed securities                          |       | 9,715                                             |       | 206 |   | 4.26 |   | 12,745 |   | 273 |   | 4.32 |   |
| Equity securities                                   |       | 1,636                                             |       | 30 |   | 3.69 |   | 2,103 |   | 37 |   | 3.55 |   |
| State and political subdivision securities **(1)**  |       | 9,509                                             |       | 311 |   | 6.58 |   | 10,350 |   | 326 |   | 6.35 |   |
| Corporate bonds                                     |       | 3,084                                             |       | 76 |   | 4.96 |   | 5,172 |   | 185 |   | 7.21 |   |
| Loans **(2) (3) (4)**                     |       | 785,939                                           |       | 27,380 |   | 7.01 |   | 724,400 |   | 28,305 |   | 7.88 |   |
| FHLB stock                                          |       | 7,769                                             |       | 204 |   | 5.28 |   | 7,621 |   | 243 |   | 6.43 |   |
| Interest bearing deposits                           |       | 1,043                                             |       | 18 |   | 3.47 |   | 1,376 |   | 37 |   | 5.42 |   |
| **Total interest earning assets**                   |       | 826,718                                           |       | 28,385 |   | 6.90 |   | 784,354 |   | 29,779 |   | 7.66 |   |
| Less: Allowance for loan losses                     |       | (8,291                                            | )          |   |   |   |   | (7,731 | ) |   |   |   |   |
| Non-interest earning assets                         |       | 70,660                                            |       |   |   |   |   | 60,403 |   |   |   |   |   |
| **Total assets**                                    |       | $                                                 | 889,087    |   |   |   |   |   | $ | 837,026 |   |   |   |   |   |
|                                                |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**       |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Interest bearing liabilities:                       |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Savings accounts                                    |       | $                                                 | 101,482    |   | $ | 947 |   | 1.88 | % | $ | 101,903 |   | $ | 1,686 |   | 3.34 | % |
| NOW and money market accounts                       |       | 131,740                                           |       | 756 |   | 1.15 |   | 119,802 |   | 968 |   | 1.63 |   |
| Certificates of deposit and other time  deposits    |       | 417,315                                           |       | 8,791 |   | 4.24 |   | 417,627 |   | 9,733 |   | 4.70 |   |
| Short term borrowings                               |       | 36,502                                            |       | 505 |   | 2.78 |   | 36,135 |   | 988 |   | 5.51 |   |
| FHLB advances                                       |       | 53,043                                            |       | 1,197 |   | 4.54 |   | 29,834 |   | 676 |   | 4.57 |   |
| Subordinated debentures                             |       | 11,333                                            |       | 334 |   | 5.93 |   | 10,000 |   | 382 |   | 7.70 |   |
| **Total interest bearing liabilities**              |       | 751,415                                           |       | 12,530 |   | 3.35 |   | 715,301 |   | 14,433 |   | 4.07 |   |
| Non-interest bearing liabilities:                   |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest bearing deposits                       |       | 56,967                                            |       |   |   |   |   | 44,041 |   |   |   |   |   |
| Other liabilities                                   |       | 5,513                                             |       |   |   |   |   | 5,316 |   |   |   |   |   |
| **Total liabilities**                               |       | 813,895                                           |       |   |   |   |   | 764,658 |   |   |   |   |   |
|                                                |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| Stockholders’ equity                           |       | 75,192                                            |       |   |   |   |   | 72,368 |   |   |   |   |   |
| **Total liabilities and stockholders’ equity** |       | $                                                 | 889,087    |   |   |   |   |   | $ | 837,026 |   |   |   |   |   |
|                                                |       |                                              |       |   |   |   |   |   |   |   |   |   |   |
| **Net interest income**                             |       |                                              |       | $ | 15,855 |   |   |   |   |   | $ | 15,346 |   |   |   |
| **Net interest spread**                             |       |                                              |       |   |   | 3.55 | % |   |   |   |   | 3.59 | % |
| **Net interest margin**                             |       |                                              |       |   |   | 3.86 | % |   |   |   |   | 3.95 | % |

 

----

| **(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                                                                                                |

 

22

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**RATE/VOLUME ANALYSIS**

 

Thetable below provides information regarding changes in interest income andinterest expense for the indicated periods. For each category of interest-earning assets and interest-bearingliabilities, information is provided on changes attributable to (1) changesin rate (changes in rate multiplied by old volume); (2) changes in volume(change in volume multiplied by old rate); and (3) changes in rate-volume(change in rate multiplied by change in volume).  Changes in rate-volume are proportionatelyallocated between rate and volume variance.

 
| ** **                                       | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended**      | ** ** |
|--------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **June 30,**                   | ** ** | **June 30,**                   | ** ** |
| ** **                                       | ** ** | **2008 vs. 2007**         | ** ** | **2008 vs. 2007**         | ** ** |
| ** **                                       | ** ** | **Increase (decrease)**        | ** ** | **Increase (decrease)**        | ** ** |
| ** **                                       | ** ** | **Due to change in** | ** ** | **Due to change in** | ** ** |
| ** **                                       | ** ** | ** **                          | ** ** | ** **                          | ** ** | **Net** | ** ** | ** ** | ** ** | ** ** | ** ** | **Net** | ** ** |
| **(Dollars in thousands)**             | ** ** | **Rate**                            | ** ** | **Volume**                          | ** ** | **Change** | ** ** | **Rate** | ** ** | **Volume** | ** ** | **Change** | ** ** |
| **Interest income:**                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| U.S. Treasury and agencies                       |       | $                                   | 35         |                                | $          | (166 | ) | $ | (131 | ) | $ | 34 |   | $ | (247 | ) | $ | (213 | ) |
| Mortgage-backed securities                       |       | (3                                  | )          | (34                                 | )          | (37 | ) | (3 | ) | (64 | ) | (67 | ) |
| Equity securities                                |       | 2                                   |       | (4                                  | )          | (2 | ) | 1 |   | (8 | ) | (7 | ) |
| State and political subdivision securities       |       | 10                                  |       | (14                                 | )          | (4 | ) | 12 |   | (27 | ) | (15 | ) |
| Corporate bonds                                  |       | (35                                 | )          | —                              |       | (35 | ) | (109 | ) | — |   | (109 | ) |
| Loans                                            |       | (2,286                              | )          | 1,270                               |       | (1,016 | ) | (3,215 | ) | 2,290 |   | (925 | ) |
| FHLB stock                                       |       | (24                                 | )          | 5                                   |       | (19 | ) | (43 | ) | 4 |   | (39 | ) |
| Interest bearing deposits                        |       | (9                                  | )          | 7                                   |       | (2 | ) | (12 | ) | (7 | ) | (19 | ) |
|                                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Total interest earning assets**                |       | (2,310                              | )          | 1,064                               |       | (1,246 | ) | (3,335 | ) | 1,941 |   | (1,394 | ) |
|                                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Interest expense:**                            |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| Savings accounts                                 |       | (446                                | )          | 57                                  |       | (389 | ) | (732 | ) | (7 | ) | (739 | ) |
| NOW and money market accounts                    |       | (233                                | )          | 64                                  |       | (169 | ) | (302 | ) | 90 |   | (212 | ) |
| Certificates of deposit and other time  deposits |       | (954                                | )          | (121                                | )          | (1,075 | ) | (935 | ) | (7 | ) | (942 | ) |
| Short term borrowings                            |       | (230                                | )          | —                              |       | (230 | ) | (483 | ) | — |   | (483 | ) |
| FHLB advances                                    |       | 18                                  |       | 243                                 |       | 261 |   | (3 | ) | 524 |   | 521 |   |
| Subordinated debentures                          |       | (24                                 | )          | 37                                  |       | 13 |   | (95 | ) | 47 |   | (48 | ) |
|                                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Total interest bearing liabilities**           |       | (1,869                              | )          | 280                                 |       | (1,589 | ) | (2,550 | ) | 647 |   | (1,903 | ) |
|                                             |       |                                |       |                                |       |   |   |   |   |   |   |   |   |
| **Net change in net interest income**            |       | $                                   | (441       | )                                   | $          | 784 |   | $ | 343 |   | $ | (785 | ) | $ | 1,294 |   | $ | 509 |   |

 

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

 

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

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|
| **(Dollars in thousands)**      | ** ** | **2008**                                        | ** ** | **2007** | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest income**                   | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer service fees on deposit accounts |       | $                                               | 1,632      |   | $ | 1,489 |   | $ | 143 |   | 9.6 | % |
| Gain on sale of mortgage loans            |       | 239                                             |       | 166 |   | 73 |   | 44.0 | % |
| Losses on securities transactions         |       | (216                                            | )          | — |   | (216 | ) | 100.0 | % |
| Brokerage commissions                     |       | 125                                             |       | 106 |   | 19 |   | 17.9 | % |
| Other income                              |       | 360                                             |       | 278 |   | 82 |   | 29.5 | % |
|                                      |       | $                                               | 2,140      |   | $ | 2,039 |   | $ | 101 |   | 5.0 | % |

 

23

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| ** **                                        | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------|------------|
| **(Dollars in thousands)**              | ** ** | **2008**                                      | ** ** | **2007** | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest income**                           | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer service fees on deposit accounts         |       | $                                             | 3,048      |   | $ | 2,763 |   | $ | 285 |   | 10.3 | % |
| Gain on sale of mortgage loans                    |       | 387                                           |       | 292 |   | 95 |   | 32.5 | % |
| Gain on sale of real estate held for  development |       | —                                        |       | 227 |   | (227 | ) | -100.0 | % |
| Losses on securities transactions                 |       | (216                                          | )          | — |   | (216 | ) | 100.0 | % |
| Brokerage commissions                             |       | 243                                           |       | 202 |   | 41 |   | 20.3 | % |
| Other income                                      |       | 632                                           |       | 500 |   | 132 |   | 26.4 | % |
|                                              |       | $                                             | 4,094      |   | $ | 3,984 |   | $ | 110 |   | 2.8 | % |

 

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

 

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

 

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

 

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

 
| ** **                             | ** ** | **Three Months Ended  June 30,** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|
| **(Dollars in thousands)**   | ** ** | **2008**                                        | ** ** | **2007** | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest expenses**              | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Employee compensation and benefits     |       | $                                               | 3,480      |   | $ | 3,105 |   | $ | 375 |   | 12.1 | % |
| Office occupancy expense and equipment |       | 679                                             |       | 596 |   | 83 |   | 13.9 | % |
| Marketing and advertising              |       | 209                                             |       | 217 |   | (8 | ) | -3.7 | % |
| Outside services and data processing   |       | 766                                             |       | 670 |   | 96 |   | 14.3 | % |
| Bank franchise tax                     |       | 253                                             |       | 234 |   | 19 |   | 8.1 | % |
| Other expense                          |       | 1,130                                           |       | 979 |   | 151 |   | 15.4 | % |
|                                   |       | $                                               | 6,517      |   | $ | 5,801 |   | $ | 716 |   | 12.3 | % |

 
| ** **                             | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------|------------|-----------------------------------------------|------------|
| **(Dollars in thousands)**   | ** ** | **2008**                                      | ** ** | **2007** | ** ** | **Change** | ** ** | **%** | ** ** |
| **Non-interest expenses**              | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Employee compensation and benefits     |       | $                                             | 6,898      |   | $ | 6,229 |   | $ | 669 |   | 10.7 | % |
| Office occupancy expense and equipment |       | 1,332                                         |       | 1,162 |   | 170 |   | 14.6 | % |
| Marketing and advertising              |       | 423                                           |       | 449 |   | (26 | ) | -5.8 | % |
| Outside services and data processing   |       | 1,483                                         |       | 1,336 |   | 147 |   | 11.0 | % |
| Bank franchise tax                     |       | 503                                           |       | 465 |   | 38 |   | 8.2 | % |
| Write off of issuance cost of          |       |                                          |       |   |   |   |   |   |   |
| Trust Preferred Securities             |       | —                                        |       | 229 |   | (229 | ) | -100.0 | % |
| Other expense                          |       | 2,213                                         |       | 1,946 |   | 267 |   | 13.7 | % |
|                                   |       | $                                             | 12,852     |   | $ | 11,816 |   | $ | 1,036 |   | 8.8 | % |

 

24

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

 

Officeoccupancy expense and equipment and outside services and data processingincreased due to additional operating expenses related to our expansionefforts.  We anticipate the increasedlevel of non-interest expense to continue in 2008 with additional retailexpansion.

 

Includedin non-interest expense for the June 2007 periods is $229,000 inunamortized subordinated debentures issuance cost from the redemption of all ofour underlying $10.0 million issuance of cumulative trust preferredsecurities.  These securities paiddistributions at a quarterly adjustable rate of LIBOR plus 360 basis points(8.97% on March 26, 2007).  Weissued new subordinated debentures at a 10 year fixed rate of 6.69%.

 

Otherexpense increased due to a new rewards program created in 2007 to increasedebit card activity, and to increases in interchange expense and REOexpense.  Interchange expense increaseddue to the switch to real-time debit card processing, which is more expensiveper item than the batch processing method we used previously. REO expenserelating to repair, maintenance and taxes increased due to increases in realestate acquired through foreclosure.

 

Ourefficiency ratio was 65% for the six months ended June 30, 2008 comparedto 61% for the 2007 period.

 

**ANALYSIS OF FINANCIAL CONDITION**

 

Total assets at June 30, 2008 increased to$969.7 million compared to $872.7 million at December 31, 2007, anincrease of $97.0 million.  Approximately$65.6 million of the increase was attributable to the recent acquisition of FSBBancshares, Inc.

 

##### **Loans**

##### ** **

Netloans increased $75.5 million to $835.6 million at June 30, 2008 comparedto $760.1 million at December 31, 2007. The recent acquisition of FSB Bancshares, Inc. contributedapproximately $48.6 million in new loans. Our commercial real estate portfolioincreased $41.6 million to $512.5 million at June 30, 2008.  For the 2008 period, these loans comprised61% of the total loan portfolio compared to 59% at June 30, 2007.  Our residential mortgage loan portfolio alsoincreased for the 2008 period due to the recent acquisition by $33.6million.  The residential mortgage loansacquired are seasoned performing loans and none are considered to have anysub-prime characteristics. Commercial, real estate construction, consumer, homeequity, and indirect consumer loans remained relatively constant during the2008 period.  For 2008, the growth incommercial real estate loans is expected to continue in line with recentperiods as we continue to emphasize this type of lending.

 
| ** **                           | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**          | ** ** | **2007**              | ** ** |
|                                 |       |              |       |                  |       |
| Commercial                           |       | $                 | 52,412     |                  | $          | 52,595 |   |
| Real estate commercial               |       | 512,521           |       | 470,929               |       |
| Real estate construction             |       | 19,241            |       | 21,383                |       |
| Residential mortgage                 |       | 165,978           |       | 132,329               |       |
| Consumer and home equity             |       | 65,071            |       | 63,090                |       |
| Indirect consumer                    |       | 26,853            |       | 27,721                |       |
| Loans held for sale                  |       | 3,186             |       | 780                   |       |
|                                 |       | 845,262           |       | 768,827               |       |
| Less:                                | ** ** | ** **        | ** ** | ** **            | ** ** |
| Net deferred loan origination fees   |       | (720              | )          | (791                  | )          |
| Allowance for loan losses            |       | (8,917            | )          | (7,922                | )          |
|                                 |       | (9,637            | )          | (8,713                | )          |
| ** **                           | ** ** | ** **        | ** ** | ** **            | ** ** |
| Loans                                |       | $                 | 835,625    |                  | $          | 760,114 |   |

 

25

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**Allowance and Provision for Loan Losses**

 

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

 

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

 

The following table analyzes loan loss experiencefor the periods indicated.

 
| ** **                                                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **(Dollars in thousands)**                                      | ** ** | **2008**                                        | ** ** | **2007**                                      | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                      |       |                                            |       |                                          |       |   |   |   |   |
| **Balance at beginning of period**                                        |       | $                                               | 8,395      |                                          | $          | 7,730 |   | $ | 7,922 |   | $ | 7,684 |   |
| Allowance related to acquisition                                          |       | 327                                             |       | —                                        |       | 327 |   | — |   |
| Loans charged-off:                                                        |       |                                            |       |                                          |       |   |   |   |   |
| Real estate mortgage                                                      |       | 15                                              |       | —                                        |       | 15 |   | — |   |
| Consumer                                                                  |       | 136                                             |       | 95                                            |       | 264 |   | 184 |   |
| Commercial                                                                |       | 274                                             |       | —                                        |       | 295 |   | 17 |   |
| Total charge-offs                                                         |       | 425                                             |       | 95                                            |       | 574 |   | 201 |   |
| Recoveries:                                                               |       |                                            |       |                                          |       |   |   |   |   |
| Real estate mortgage                                                      |       | 1                                               |       | 1                                             |       | 1 |   | 9 |   |
| Consumer                                                                  |       | 87                                              |       | 57                                            |       | 125 |   | 119 |   |
| Commercial                                                                |       | 18                                              |       | 2                                             |       | 18 |   | 3 |   |
| Total recoveries                                                          |       | 106                                             |       | 60                                            |       | 144 |   | 131 |   |
|                                                                      |       |                                            |       |                                          |       |   |   |   |   |
| **Net loans charged-off**                                                 |       | 319                                             |       | 35                                            |       | 430 |   | 70 |   |
|                                                                      |       |                                            |       |                                          |       |   |   |   |   |
| Provision for loan losses                                                 |       | 514                                             |       | 127                                           |       | 1,098 |   | 208 |   |
|                                                                      |       |                                            |       |                                          |       |   |   |   |   |
| **Balance at end of period**                                              |       | $                                               | 8,917      |                                          | $          | 7,822 |   | $ | 8,917 |   | $ | 7,822 |   |
|                                                                      |       |                                            |       |                                          |       |   |   |   |   |
| Allowance for loan losses to total loans (excluding  loans held for sale) |       |                                            |       |                                          |       | 1.06 | % | 1.07 | % |
| Annualized net charge-offs to average loans  outstanding                  | ** ** | ** **                                      |       |                                          | ** ** | 0.11 | % | 0.02 | % |
| Allowance for loan losses to total  non-performing loans                  | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | 59 | % | 103 | % |

 

Theprovision for loan losses increased $387,000 to $514,000 for the quarter ended June 30,2008, and increased $890,000 to $1.1 million for the six months ended June 30,2008 compared to the same periods in 2007 due to growth in the loan portfolioas well as a specific allocation for a loan classified during the first quarterof 2008.  The provision for the 2007period was smaller due to the improved performance of one of our creditrelationships which reduced the allowance allocated to the loan.  The allowance for loan losses increased $1.1million to $8.9 million from June 30, 2007 to June 30, 2008. ** **Theincrease was related to $327,000 in allowance added as a result of the FSBBancshares, Inc. acquisition, an increase in net loans for 2008, as wellas provision recorded, in conjunction with a $21.6 million increase inclassified loans for the 2008 period.

 

26

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

 

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

** **
| ** **                           | ** ** | **June 30,** | ** ** |
|--------------------------------------|------------|-------------------|------------|
| **(Dollars in thousands)** | ** ** | **2008**          | ** ** | **2007** | ** ** |
| **Classified Loans**                 | ** ** | ** **        | ** ** | ** ** | ** ** |
| Substandard                          |       | $                 | 35,746     |   | $ | 14,114 |   |
| Doubtful                             |       | —            |       | 25 |   |
| Loss                                 |       | 52                |       | 36 |   |
| Total Classified                     |       | $                 | 35,798     |   | $ | 14,175 |   |

 

The$21.6 million increase in substandard assets for 2008 was primarily the result****of downgrading loans with nine borrowersin the amounts of $12.3 million, $4.1 million, $1.6 million, $1.5 million, $1.3million, $1.0 million, $975,000, $845,000 and $800,000,****respectively.** **Offsetting thisincrease was the upgrade of a classified loan having a balance of $823,000 andthe transfer of two classified loans having balances of $1.5 million and $1.1million to real estate acquired through foreclosure. Approximately $28.0million of the total classified loans were related to real estate developmentor real estate construction loans in our market area.  Classified consumer loans totaled $ 1.1million, classified mortgage loans totaled $4.0 million and classifiedcommercial loans totaled $2.7 million. We remain well secured and adequately collateralized with these credits.For more information on collection efforts, evaluation of collateral and howloss amounts are estimated, see “Non-Performing Assets.”

 

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

 

##### **Non-Performing Assets**

##### ** **

Non-performing assets consist of certainrestructured loans for which interest rate or other terms have beenrenegotiated, loans on which interest is no longer accrued, real estate acquiredthrough foreclosure and repossessed assets. We do not have any loans greaterthan 90 days past due still on accrual. Loans, including impaired loans under SFAS 114, are placed onnon-accrual status when they become past due 90 days or more as to principal orinterest, unless they are adequately secured and in the process ofcollection.  Loans are consideredimpaired when we no longer anticipate full principal or interest payments inaccordance with the contractual loan terms. We carry impaired loans at the present value of expected future cashflows discounted at the loan’s effective interest rate or at the fair value ofthe collateral if the loan is secured by collateral.

 

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

 

Werecognize interest income on loans on the accrual basis except for those loansin a non-accrual of income status. We discontinue accruing interest on impairedloans when management believes, after consideration of economic and businessconditions and collection efforts that the borrowers’ financial condition issuch that collection of interest is doubtful, typically after the loan becomes90 days delinquent.  When we discontinueinterest accrual, we reverse existing accrued interest and subsequentlyrecognize interest income only to the extent we receive cash payments.

 

We classify real estate acquired as a result offoreclosure or by deed in lieu of foreclosure as real estate owned until suchtime as it is sold. We classify new and used automobile, motorcycle and allterrain vehicles acquired as 

 

27

----

 

a result of foreclosure as repossessed assets untilthey are sold. When such property is acquired we record it at the lower of theunpaid principal balance of the related loan or its fair market value.  We charge any write-down of the property atthe time of acquisition to the allowance for loan losses.  Subsequent gains and losses are included innon-interest income and non-interest expense. Real estate acquired through foreclosure increased $1.7 million to $3.5million at June 30, 2008.  Theincrease was primarily the result of a commercial credit relationship totaling$1.1 million that was transferred during the quarter.

 

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

 
| ** **                                                           | ** **                                                            | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------|-----------------------------------------------------------------------|-------------------|------------|-----------------------|------------|
| **(Dollar in thousands)**                                  | ** **                                                            | **2008**          | ** ** | **2007**              | ** ** |
| ** **                                                           | ** **                                                            | ** **        | ** ** | ** **            | ** ** |
| Restructured                                                         |                                                                  | $                 | 861        |                  | $          | 2,335 |   |
| Past due 90 days still on accrual                                    |                                                                  | —            |       | —                |       |
| Loans on non-accrual status                                          |                                                                  | 14,352            |       | 6,554                 |       |
|                                                                 |                                                                  |              |       |                  |       |
| Total non-performing loans                                           |                                                                  | 15,213            |       | 8,889                 |       |
| Real estate acquired through foreclosure                             |                                                                  | 3,459             |       | 1,749                 |       |
| Other repossessed assets                                             |                                                                  | 52                |       | 52                    |       |
| Total non-performing assets                                          |                                                                  | $                 | 18,724     |                  | $          | 10,690 |   |
|                                                                 |                                                                  |              |       |                  |       |
| Interest income that would have been earned  on non-performing loans |                                                                  | $                 | 1,066      |                  | $          | 696 |   |
| Interest income recognized on  non-performing loans                  |                                                                  | 117               |       | 188                   |       |
| Ratios:                                                              | Non-performing loans to total loans (excluding  loans held for sale)  |              | 1.81       | %                     | 1.16       | % |
|                                                                 | Non-performing assets to total loans (excluding  loans held for sale) |              | 2.23       | %                     | 1.39       | % |

 

Non-performingloans increased $6.3 million to $15.2 million at June 30, 2008 compared to$8.9 million at December 31, 2007. The increase in non-accrual loans consist primarily of five creditrelationships totaling $4.1 million, $1.3 million, $913,000, $822,000 and$779,000. These credit relationships are well secured by real estate and noloss is expected.

 

Non-performingassets for the 2008 period include $861,000 in restructured commercial,mortgage and consumer loans. Restructured loans primarily consist of four credit relationships withbalances of $300,000, $217,000, $143,000 and $119,000. The terms of these loanshave been renegotiated to reduce the rate of interest and extend the term, thusreducing the amount of cash flow required from the borrower to service theloans. The borrowers are currently meeting the terms of the restructured loans.  The decrease in restructured loans from December 31,2007 was primarily due to the removal of one credit relationship totaling $2.0million from the restructured loan category since the terms of the loan are nowsubstantially equivalent to terms on which loans with comparable risks arebeing made and the borrower has performed per the terms of the contract.

 

**Investment Securities**

 

Intereston securities provides us our largest source of interest income after intereston loans, constituting 3.2% of the total interest income for the six monthsended June 30, 2008.  The securitiesportfolio serves as a source of liquidity and earnings and contributes to themanagement of interest rate risk.  Wehave the authority to invest in various types of liquid assets, includingshort-term United States Treasury obligations and securities of various federalagencies, obligations of states and political subdivisions, corporate bonds,certificates of deposit at insured savings and loans and banks, bankers’acceptances, and federal funds.  We mayalso invest a portion of our assets in certain commercial paper and corporatedebt securities.  We are also authorizedto invest in mutual funds and stocks whose assets conform to the investmentsthat we are authorized to make directly. The available-for-sale and held-to-maturityinvestment portfolios decreased by $11.4 million during the 2008 period assecurities were called for redemption in accordance with their terms due todecreasing rates.  During the June 2008period we did not purchase any new investment securities. The FSB Bancshares, Inc.acquisition contributed approximately $2.0 million in held-to-maturity federalagencies and obligations of states and political subdivisions.

 

28

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We review all unrealized lossesat least on a quarterly basis to determine whether the losses are other thantemporary and more frequently when economic or market concerns warrant suchevaluation. We consider the length of time and the extent to which the fairvalue has been less than cost, the financial condition and near-term prospectsof the issuer, and our intent and ability to retain the investment in theissuer for a period of time sufficient to allow for any anticipated recovery infair value.  In analyzing an issuer’sfinancial condition, we may consider whether the securities are issued by thefederal government or its agencies, whether downgrades by bond rating agencieshave occurred, and the results of reviews of the issuer’s financial condition.

 

The unrealized losses on ourtemporarily impaired debt securities are a result of changes in interest ratesfor fixed-rate securities where the interest rate received is less than thecurrent rate available for new offerings of similar securities. Because thedecline in market value is attributable to changes in interest rates and notcredit quality, and because we have the ability and intent to hold theseinvestments until recovery of fair value, which may be maturity, we do notconsider these investments to be other-than-temporarily impaired at June 30,2008.

 

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

 

###### **Deposits**

###### ** **

Werely primarily on providing excellent customer service and long-standingrelationships with customers to attract and retain deposits. Market interestrates and rates on deposit products offered by competing financial institutionscan significantly affect our ability to attract and retain deposits.  In conjunction with our initiatives to expandand enhance our retail branch network, we emphasize growing our customerchecking account base to better enhance profitability and franchise value.  Total deposits increased $95.8 million yearto date compared to December 31, 2007. The recent acquisition of FSBBancshares, Inc. contributed approximately $55.8 million in deposits.Retail and commercial depositsincreased $100.4 million which was offset by a $4.6 million decrease in publicfunds and brokered certificates for the 2008 period. Brokered deposits were $23.3 million at June 30,2008 compared to $24.3 million at December 31, 2007.

 

Thefollowing table breaks down our deposits.

 
| ** **              | ** ** | **June 30,**       | ** ** | **December 31,** | ** ** |
|-------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **              | ** ** | **2008**                | ** ** | **2007**              | ** ** |
| ** **              | ** ** | **(In Thousands)** | ** ** |
|                    |       |                    |       |                  |       |
| Non-interest bearing    |       | $                       | 77,124     |                  | $          | 46,978 |   |
| NOW demand              |       | 93,692                  |       | 79,133                |       |
| Savings                 |       | 112,442                 |       | 91,249                |       |
| Money market            |       | 45,425                  |       | 49,306                |       |
| Certificates of deposit |       | 456,403                 |       | 422,577               |       |
|                    |       | $                       | 785,086    |                  | $          | 689,243 |   |

 

**Short-Term Borrowings**

 

We have the ability to obtain short-term borrowings,consisting of federal funds purchased and securities sold under agreements torepurchase.  We had short-term borrowingsof $33.0 million and $40.5 million from the FHLB of Cincinnati at June 30,2008 and 2007.  These borrowings averageda rate of 2.78% and 5.51% for 2008 and 2007.

 

**Advances from Federal Home Loan Bank**

 

Depositsare the primary source of funds for our lending and investment activities andfor our general business purposes.  Wecan also use advances (borrowings) from the Federal Home Loan Bank (FHLB) ofCincinnati to compensate for reductions in deposits or deposit inflows at lessthan projected levels.  Advances from theFHLB are secured by our stock in the FHLB, certain securities, certaincommercial real estate loans and substantially all of our first mortgage,multi-family and open end home equity loans. At June 30, 2008 we had $53.0 million in advances outstanding fromthe FHLB and the capacity to increase our borrowings an additional $53.3million.

 

29

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**Subordinated Debentures**

 

On June 24, 2008, First Federal Statutory TrustIII, an unconsolidated trust subsidiary of First Financial Service Corporation,issued $8.0 million in trust preferred securities.  The trust loaned the proceeds of the offeringto us in exchange for junior subordinated deferrable interest debentures whichwe used to finance the purchase of FSB Bancshares, Inc.  In accordance with FASB Interpretation 46,the trust is not consolidated with our financial statements but rather thesubordinated debentures are shown as a liability.  The subordinated debentures, which mature on June 24,2038, can be called at par in whole or in part on or after June 24, 2018.The subordinated debentures pay a fixed rate of 8% for thirty years.  We have the option to defer interest paymentson the subordinated debt from time to time for a period not to exceed fiveconsecutive years.  The subordinateddebentures are considered as Tier I capital for the Corporation under currentregulatory guidelines.

 

Another trust we formed in 2002, completed a privateplacement of 10,000 shares of cumulative trust preferred securities with aliquidation preference of $1,000 per security for a total outstanding of $10.0million.  These securities paydistributions of interest. On March 26, 2007 we called the $10.0 millionin subordinated debentures adjustable quarterly at LIBOR plus 360 basis points(8.97% on March 26, 2007) and issued new 30 year cumulative trustpreferred securities at a 10 year fixed rate of 6.69% adjusting quarterlythereafter at LIBOR plus 160 basis points. The subordinated debentures, which mature March 22, 2037, can becalled at par in whole or in part on or after March 15, 2017.  We have the option to defer interest paymentson the subordinated debt from time to time for a period not to exceed fiveconsecutive years. The subordinated debentures are considered as Tier I capitalfor the Corporation under current regulatory guidelines.

 

The trust loaned the proceeds of the offering to usin exchange for junior subordinated deferrable interest debentures. Inaccordance with FASB Interpretation 46, the trust is not consolidated with ourfinancial statements but rather the subordinated debentures are shown as aliability.

 

##### **LIQUIDITY**

##### ** **

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

 

Our sources of funds include the sale of securities in the available-for-sale portion of the investment portfolio, the payment of principal on loans and mortgage-backed securities, proceeds realized from loans held for sale, brokered deposits and other wholesale funding.  We also secured federal funds borrowing lines from two of our correspondent banks of $15 million each.  Our banking centers also provide access to retail deposit markets.  If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources.  Traditionally, we have also borrowed from the FHLB to supplement our funding requirements.  At June 30, 2008, we had an unused approved line of credit in the amount of $102.2 million and sufficient collateral available to borrow, approximately, an additional $53.3 million in advances from the FHLB.**** We believe our sources of liquidity are adequate to meet expected cash needs for the foreseeable future.

 

At the holding company level, the Corporation uses cash to pay dividends to stockholders, repurchase common stock, make selected investments and acquisitions, and service debt. The main sources of funding for the Corporation include dividends from the Bank, borrowings and access to the capital markets.

 

###### **Theprimary source of funding for the Corporation has been dividends and returns ofinvestment from the Bank. Kentucky banking laws limit the amount of dividendsthat may be paid to the Corporation by the Bank without prior approval of theKOFI.  Under these laws, the amount ofdividends that may be paid in any calendar year is limited to current year’snet income, as defined in the laws, combined with the retained net income ofthe preceding two years, less any dividends declared during those periods.  At June 30, 2008, the Bank hadapproximately $12.7 million of retained earnings that could be used to paydividends without prior regulatory approval. Because of these limitations, consolidated cash flows as presented inthe consolidated statements of cash flows may not represent cash immediatelyavailable to the Corporation.  During2008, the Bank declared and paid dividends of $8.3 million to theCorporation.  Included in the totaldividend payment was $6.0 million in dividends that were used to finance thepurchase of FSB Bancshares, Inc..**

 

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##### **CAPITAL**

 

Stockholders’equity increased $2.2 million for the period ended June 30, 2008 comparedto December 31, 2007 primarily due to net income earned during thequarter.  This increase was reduced bycash dividends declared during the period. Average stockholders’ equity to average assets ratio decreased to 8.46%for the six month period ended June 30, 2008 compared to 8.65% for 2007.

 

Duringthe first half of 2008, we did not purchase any shares of our own common stock.  Thecurrent repurchase program authorizes the repurchase of 398,601 shares fromtime-to-time if market conditions are deemed favorable.  Therepurchase program will remain effective until the number of shares authorizedis repurchased or until the program expires September 19, 2008.  As ofJune 30, 2008, 242,560 shares could be repurchased under the current stockrepurchase program.

 

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

 
| ** **                                          | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **To Be Considered** | ** ** |
|-----------------------------------------------------|------------|------------|------------|----------------------------|------------|----------------------------|------------|----------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Well Capitalized**      | ** ** |
| ** **                                          | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | **Under Prompt**          | ** ** |
| ** **                                          | ** ** | ** ** | ** ** | ** **                 | ** ** | **For Capital**       | ** ** | **Correction** | ** ** |
| **(Dollars in thousands)**                | ** ** | **Actual** | ** ** | **Adequacy Purposes** | ** ** | **Action Provisions** | ** ** |
| **As of June 30, 2008:**        | ** ** | **Amount** | ** ** | **Ratio**                  | ** ** | **Amount**                 | ** ** | **Ratio**      | ** ** | **Amount**                     | ** ** | **Ratio** | ** ** |
| Total risk-based capital (to risk-weighted  assets) |       |       |       |                       |       |                       |       |           |       |                           |       |   |   |
| Consolidated                                        |       | $          | 88,920     |                       | 10.7       | %                          | $          | 66,824         |       | 8.0                            | %          | N/A |   | N/A |   |
| Bank                                                |       | 85,596     |       | 10.3                       |       | 66,625                     |       | 8.0            |       | $                              | 83,282     |   | 10 | % |
| Tier I capital (to risk-weighted assets)            | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Consolidated                                        |       | 79,945     |       | 9.6                        |       | 33,412                     |       | 4.0            |       | N/A                            |       | N/A |   |
| Bank                                                |       | 76,620     |       | 9.2                        |       | 33,313                     |       | 4.0            |       | 49,969                         |       | 6 | % |
| Tier I capital (to average assets)                  | ** ** | ** ** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Consolidated                                        |       | 79,945     |       | 9.0                        |       | 35,549                     |       | 4.0            |       | N/A                            |       | N/A |   |
| Bank                                                |       | 76,620     |       | 8.6                        |       | 35,556                     |       | 4.0            |       | 44,445                         |       | 5 | % |
|                                                     |            |            |            |                            |            |                            |            |                |            |                                |            |  |  |  |  |  |

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

 

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###### **Item3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

###### **Asset/LiabilityManagement and Market Risk**

 

To minimize the volatility ofnet interest income and exposure to economic loss that may result fromfluctuating interest rates, we manage our exposure to adverse changes ininterest rates through asset and liability management activities withinguidelines established by our Asset Liability Committee (“ALCO”).  The ALCO, which includes senior managementrepresentatives, has the responsibility for approving and ensuring compliancewith asset/liability management policies. Interest rate risk is the exposure to adverse changes in the netinterest income as a result of market fluctuations in interest rates.  The ALCO, on an ongoing basis, monitorsinterest rate and liquidity risk in order to implement appropriate funding andbalance sheet strategies.  Managementconsiders interest rate risk to be our most significant market risk.

 

We utilize an earningssimulation model to analyze net interest income sensitivity.  We then evaluate potential changes in marketinterest rates and their subsequent effects on net interest income.  The model projects the effect ofinstantaneous movements in interest rates of both 100 and 200 basispoints.  We also incorporate assumptionsbased on the historical behavior of our deposit rates and balances in relationto changes in interest rates into the model. These assumptions are inherently uncertain and, as a result, the modelcannot precisely measure future net interest income or precisely predict theimpact of fluctuations in market interest rates on net interest income.  Actual results will differ from the model’ssimulated results due to timing, magnitude and frequency of interest ratechanges as well as changes in market conditions and the application and timingof various management strategies.

 

Our interest sensitivityprofile was asset sensitive at June 30, 2008 and December 31,2007.  Given a sustained 100 basis pointdecrease in rates, our base net interest income would decrease by an estimated****1.48% at June 30, 2008 compared to adecrease of 1.10% at December 31, 2007. ** **Given a 100 basis point increase ininterest rates our base net interest income would increase by an****estimated 1.57% at June 30, 2008compared to an increase of 1.09% at December 31, 2007.

 

Our interest sensitivity at anypoint in time will be affected by a number of factors.  These factors include the mix of interestsensitive assets and liabilities, their relative pricing schedules, marketinterest rates, deposit growth, loan growth, decay rates and prepayment speedassumptions.

 

We use various asset/liabilitystrategies to manage the re-pricing characteristics of our assets andliabilities designed to ensure that exposure to interest rate fluctuations islimited within our guidelines of acceptable levels of risk-taking.  As demonstrated by the June 30, 2008 andDecember 31, 2007 sensitivity tables, our balance sheet has an assetsensitive position. This means that our earning assets, which consist of loansand investment securities, will change in price at a faster rate than ourdeposits and borrowings.  Therefore, ifshort term interest rates increase, our net interest income will increase.  Likewise, if short term interest ratesdecrease, our net interest income will decrease.

 

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Our sensitivity to interestrate changes is presented based on data as of June 30, 2008 and December 31,2007 annualized to a one year period.

 
| ** **                           | ** ** | **June 30, 2008**     | ** ** |
|--------------------------------------|------------|---------------------------------|------------|
| ** **                           | ** ** | **Decrease in Rates** | ** ** | ** ** | ** ** | **Increase in Rates** | ** ** |
| ** **                           | ** ** | **200**                         | ** ** | **100** | ** ** | ** ** | ** ** | **100** | ** ** | **200** | ** ** |
| **(Dollars in thousands)** | ** ** | **Basis Points**           | ** ** | **Basis Points** | ** ** | **Base** | ** ** | **Basis Points** | ** ** | **Basis Points** | ** ** |
|                                 |       |                            |       |   |   |   |   |   |   |   |   |
| **Projected interest income**        |       |                            |       |   |   |   |   |   |   |   |   |
| Loans                                |       | $                               | 51,844     |   | $ | 53,382 |   | $ | 54,845 |   | $ | 56,289 |   | $ | 57,712 |   |
| Investments                          |       | 1,757                           |       | 1,867 |   | 1,948 |   | 2,043 |   | 2,127 |   |
| **Total interest income**            |       | 53,601                          |       | 55,249 |   | 56,793 |   | 58,332 |   | 59,839 |   |
|                                 |       |                            |       |   |   |   |   |   |   |   |   |
| **Projected interest expense**       |       |                            |       |   |   |   |   |   |   |   |   |
| Deposits                             |       | 17,005                          |       | 17,957 |   | 18,890 |   | 19,785 |   | 20,765 |   |
| Borrowed funds                       |       | 3,060                           |       | 3,162 |   | 3,262 |   | 3,361 |   | 3,460 |   |
| **Total interest expense**           |       | 20,065                          |       | 21,119 |   | 22,152 |   | 23,146 |   | 24,225 |   |
|                                 |       |                            |       |   |   |   |   |   |   |   |   |
| **Net interest income**              |       | $                               | 33,536     |   | $ | 34,130 |   | $ | 34,641 |   | $ | 35,186 |   | $ | 35,614 |   |
| Change from base                     |       | $                               | (1,105     | ) | $ | (511 | ) |   |   | $ | 545 |   | $ | 973 |   |
| % Change from base                   |       | (3.19                           | )%         | (1.48 | )% |   |   | 1.57 | % | 2.81 | % |

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

 

###### **Item4.  CONTROLS AND PROCEDURES**

###### ** **

*Evaluation of disclosure controls and procedures*

 

Ourmanagement, with the participation of our Chief Executive Officer and our ChiefFinancial Officer, evaluated the effectiveness of our disclosure controls andprocedures as of the end of the period covered by this quarterly report on Form 10-Q.Based on this evaluation, our Chief Executive Officer and our Chief FinancialOfficer have concluded that our disclosure controls and procedures wereeffective as of the end of the period covered by this Quarterly Report on Form 10-Qto ensure that information we are required to disclose in reports that we fileor submit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in Securities andExchange Commission rules and forms.

 

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*Limitations on the Effectiveness of Controls*

* *

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

 

*Changes in internal control over financial reporting*

 

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

 

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##### **Part II - OTHER INFORMATION**

 

**Item 1.****                                                          ****Legal Proceedings**

 

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

 

**Item 1A.**** ****Risk Factors**

 

Wedid not have any changes to our risk factors previously disclosed in our AnnualReport on Form 10-K for the year ended December 31, 2007.

 

**Item 2.****                                                          ****Unregistered Sales ofSecurities and Use of Proceeds**

 

(e)  Issuer Purchasesof Equity Securities

 

We did not repurchase any shares of our common stock during the quarter ended June 30, 2008.

 

**Item 3.****                                                          ****Defaults Upon SeniorSecurities**

 

NotApplicable

 

**Item 4.****                                                          ****Submission of Matters to aVote of Security Holders**

** **

Our2008 Annual Meeting of Shareholders was held on May 21, 2008.  At the meeting, the directors listed belowwere elected as directors of the Corporation for terms expiring at the annualmeeting in the year set forth to each of their names.  The voting results for the matters broughtbefore the 2008 Annual Meeting are as follows:

 

1.** **Electionof Directors.

 
| ** **           | ** ** | ** **            | ** ** | ** **         | ** ** | ** **      | ** ** | **Broker**    | ** ** |
|----------------------|------------|-----------------------|------------|--------------------|------------|-----------------|------------|---------------|------------|
| **Name**             | ** ** | **Term Expires** | ** ** | **Votes For** | ** ** | **Abstentions** | ** ** | **Non-Votes** | ** ** |
| Walter D. Huddleston |       | 2011                  |       | 3,965,052          |       | 35,022          |       | 54,255        |       |
| J. Stephen Mouser    |       | 2011                  |       | 3,975,149          |       | 35,022          |       | 54,255        |       |
| Michael L. Thomas    |       | 2011                  |       | 3,971,038          |       | 35,022          |       | 54,255        |       |

 

Inaddition, the following directors will continue in office until the annualmeeting of the year set forth beside each of their names.

 
| **Name**                  | ** ** | **Term Expires** | ** ** |
|---------------------------|------------|-----------------------|------------|
|                      |       |                  |       |
| Robert M. Brown           |       | 2010                  |       |
| B. Keith Johnson          |       | 2009                  |       |
| Diane E. Logsdon          |       | 2009                  |       |
| John L. Newcomb, Jr. |       | 2009                  |       |
| J. Alton Rider            |       | 2010                  |       |
| Donald Scheer             |       | 2009                  |       |
| Gail L. Schomp            |       | 2010                  |       |

 

###### **Item 5.**                                                           OtherInformation

 

None

 

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**Item 6.****                                                          ****Exhibits:**

** **

31.1             Certificationof Chief Executive Officer Pursuant to Section 302 of Sarbanes- Oxley Act

 

31.2             Certificationof Chief Financial Officer Pursuant to Section 302 of Sarbanes- Oxley Act

 

32                      Certification of Chief Executive Officer andChief Financial Officer Pursuant to Section 18 U.S.C. Section 1350(As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)

 

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**FIRST FINANCIAL SERVICE CORPORATION**

** **

## **SIGNATURES**

## ** **

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

 

 
| Date:  August 11,  2008 | By:  /s/ | B.  Keith Johnson                   |
|----------------------------------------|--------------------|-------------------------------------|
|                                   |               | B.  Keith Johnson                   |
|                                   |               | Chief  Executive Officer            |
|                                   |               |                                |
|                                   |               |                                |
| Date:  August 11,  2008 | By:  /s/ | Steven  M. Zagar                    |
|                                   |               | Steven M. Zagar                     |
|                                   |               | Chief  Financial Officer & |
|                                   |               | Principal  Accounting Officer       |

 

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## **INDEX TO EXHIBITS**

## ** **

| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                             |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **           | ** ** | ** **                                                                                                                                                                                  |
| 31.1                 |       | Certification  of Chief Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                                |
|                 |       |                                                                                                                                                                                        |
| 31.2                 |       | Certification  of Chief Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act                                                                                                |
|                 |       |                                                                                                                                                                                        |
| 32                   |       | Certification  of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350 (As Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002) |

 

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