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** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 

**(MarkOne)**

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

 

**For the quarterly period ended March 31, 2010**

 

**OR**

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

 

**For the transition period from                 to                 .**

 

**Commission File No. 0-12870.**

 

**FIRST CHESTER COUNTY CORPORATION**

(Exact name of Registrant asspecified in its charter)

 

| **Pennsylvania**                                               | ** ** | **23-2288763**                       |
|----------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of Incorporation or organization) |       | (I.R.S. Employer Identification No.) |

 

**9 North High Street**

**West Chester, Pennsylvania 19380**

(Address of principalexecutive office)

(Zip code)

 

**(484) 881-4000**

(Registrant’s telephonenumber, including area code)

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  Yes x  No o

 

Indicateby check mark whether the registrant has submitted electronically and posted onits corporate Web site, if any, every Interactive Data File required to besubmitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 ofthis chapter) during the preceding 12 months (or for such shorter period thatthe registrant was required to submit and post such files). Yes o  No o

 

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

 

| Large accelerated filer o                     |   | Accelerated filer x         |
|-----------------------------------------------|--------|-----------------------------|
|                                          |   |                        |
| Non-accelerated filer o                       |   | Smaller reporting company o |
| (Do not check if a smaller reporting company) |   |                        |

 

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

 

Thenumber of shares outstanding of Common Stock of the registrant as of July 30,2010 was 6,318,611.

 

 

 

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** **

**INDEX**

 
| ** **                 | ** **            | ** **                                                                                                | ** **   | **Page**     |
|----------------------------|-----------------------|-----------------------------------------------------------------------------------------------------------|--------------|--------------|
| FORWARD-LOOKING STATEMENTS |                  |                                                                                                      |
|                       |                  |                                                                                                      |         |         |
| Part I.               | FINANCIAL INFORMATION |                                                                                                      |         |
|                       |                  |                                                                                                      |         |         |
|                       | Item 1 -              | Financial Statements                                                                                      |         |         |
|                       |                  | Consolidated Balance Sheets March 31, 2010  (unaudited) and December 31, 2009                   |         |         |
|                       |                  |                                                                                                      |         |         |
|                       |                  | Consolidated Statements of Operations Three Months  Ended March 31, 2010 (unaudited) and 2009 (unaudited) |         |         |
|                       |                  |                                                                                                      |         |         |
|                       |                  | Consolidated Statements of Cash Flows Three Months  Ended March 31, 2010 (unaudited) and 2009 (unaudited) |         |         |
|                       |                  |                                                                                                      |         |         |
|                       |                  | Consolidated Statements of Equity Three Months Ended  March 31, 2010 (unaudited) 2009 (unaudited)    |         |         |
|                       |                  |                                                                                                      |         |         |
|                       |                  | Notes to Consolidated Financial Statements (unaudited)                                                    |         |         |
|                       |                  |                                                                                                      |         |         |
|                       | 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 &  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 -              | [Removed  and Reserved]                                                                                   |         |         |
|                       |                  |                                                                                                      |         |         |
|                       | Item 5 -              | Other  Information                                                                                        |         |         |
| *** ***               | *** ***          | *** ***                                                                                              | *** *** | *** *** |
|                       | Item 6 -              | Exhibits                                                                                                  |         |         |
| *** ***               | *** ***          | *** ***                                                                                              | *** *** | *** *** |
| Signatures                 |                  |                                                                                                      |         |         |
|                       |                  |                                                                                                      |         |         |
| Exhibits                   |                  |                                                                                                      |         |         |

 

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**FORWARD-LOOKINGSTATEMENTS**

 

This Quarterly Report onForm 10-Q contains “forward-looking statements.”  These forward-looking statements are made ingood faith pursuant to the “safe harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995.  The words“may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,”“intend,” “plan” and similar expressions are intended to identifyforward-looking statements. References to “we,” “our” and the “Corporation”refer to First Chester County Corporation, together in each case with ourconsolidated subsidiaries unless the context suggests otherwise.

 

The forward-looking statements contained in this Quarterly Report onForm 10-Q are based on current expectations, estimates, forecasts andprojections about the industry in which we operate and management’s beliefs andassumptions. These statements are not guarantees of future performance andinvolve risks, uncertainties and assumptions that are difficult to predict.Therefore, actual outcomes and results may differ materially from what isexpressed or forecasted in such forward-looking statements, including as aresult of risks discussed in “Part I, Item 1A. Risk Factors” in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2009, andin this Quarterly Report on Form 10-Q.

 

i

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

**PART I. FINANCIALINFORMATION**

 

**ITEM 1.  Financial Statements**

 

**CONSOLIDATED BALANCE SHEETS**

 

 
| ** **                                                                                                                                                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(Dollars  in thousands)**                                                                                                                                   | ** ** | **2010**           | ** ** | **2009**              | ** ** |
| ** **                                                                                                                                                    | ** ** | **(Unaudited)**    | ** ** | ** **            | ** ** |
| ASSETS                                                                                                                                                        |       |               |       |                  |       |
| Cash and due from banks                                                                                                                                       |       | $                  | 16,866     |                  | $          | 20,853 |   |
| Federal funds sold and other overnight investments                                                                                                            |       | 1,062              |       | 1,721                 |       |
| Interest bearing deposits                                                                                                                                     |       | 189,534            |       | 124,107               |       |
| Total cash and cash equivalents                                                                                                                               |       | 207,462            |       | 146,681               |       |
|                                                                                                                                                          |       |               |       |                  |       |
| Investment securities available-for-sale, at fair  value                                                                                                      |       | 65,296             |       | 82,698                |       |
|                                                                                                                                                          |       |               |       |                  |       |
| Loans and leases                                                                                                                                              |       | 884,269            |       | 901,889               |       |
| Less: allowance for loan and lease losses                                                                                                                     |       | (22,464            | )          | (23,217               | )          |
| Net loans and leases                                                                                                                                          |       | 861,805            |       | 878,672               |       |
|                                                                                                                                                          |       |               |       |                  |       |
| Premises and equipment, net                                                                                                                                   |       | 19,799             |       | 20,513                |       |
| Deferred tax asset, net                                                                                                                                       |       | 2,325              |       | 2,593                 |       |
| Bank owned life insurance                                                                                                                                     |       | 1,492              |       | 1,474                 |       |
| Other real estate owned                                                                                                                                       |       | 2,918              |       | 3,692                 |       |
| Other assets                                                                                                                                                  |       | 22,296             |       | 32,560                |       |
| Discontinued assets (see Note 6):                                                                                                                             |       |               |       |                  |       |
| Mortgage loans and related derivative instruments                                                                                                             |       | 106,311            |       | 205,150               |       |
| Other discontinued assets held for sale                                                                                                                       |       | 3,261              |       | 3,203                 |       |
| Total assets                                                                                                                                                  |       | $                  | 1,292,965  |                  | $          | 1,377,236 |   |
| LIABILITIES                                                                                                                                                   |       |               |       |                  |       |
| Deposits                                                                                                                                                      |       |               |       |                  |       |
| Non-interest-bearing                                                                                                                                          |       | $                  | 153,601    |                  | $          | 155,647 |   |
| Interest-bearing (including certificates of  deposit over $100 thousand of $207,762 and $250,757 at March 31, 2010 and  December 31, 2009, respectively) |       | 919,239            |       | 954,653               |       |
| Total deposits                                                                                                                                                |       | 1,072,840          |       | 1,110,300             |       |
| Federal Home Loan Bank advances and other  borrowings                                                                                                         |       | 130,254            |       | 172,897               |       |
| Subordinated debentures                                                                                                                                       |       | 20,795             |       | 20,795                |       |
| Other liabilities                                                                                                                                             |       | 11,031             |       | 13,097                |       |
| Discontinued liabilities (see Note 6)                                                                                                                         |       | 3,174              |       | 3,245                 |       |
| Total liabilities                                                                                                                                             |       | 1,238,094          |       | 1,320,334             |       |
|                                                                                                                                                          |       |               |       |                  |       |
| EQUITY                                                                                                                                                        |       |               |       |                  |       |
| Common stock, par value $1.00; authorized  25,000,000 shares; Outstanding, 6,354,475 at March 31, 2010  and  December 31, 2009                      |       | 6,354              |       | 6,354                 |       |
| Additional paid-in capital                                                                                                                                    |       | 23,714             |       | 23,678                |       |
| Retained earnings                                                                                                                                             |       | 23,952             |       | 25,753                |       |
| Accumulated other comprehensive income (loss)                                                                                                                 |       | 29                 |       | (499                  | )          |
| Treasury stock, at cost: 28,945 shares and 13,702  shares at March 31, 2010 and December 31, 2009, respectively                                          |       | (366               | )          | (209                  | )          |
| Total First Chester County Corporation  stockholders’ equity                                                                                             |       | 53,683             |       | 55,077                |       |
| Non-controlling interests                                                                                                                                     |       | 1,188              |       | 1,825                 |       |
| Total equity                                                                                                                                                  |       | 54,871             |       | 56,902                |       |
|                                                                                                                                                          |       |               |       |                  |       |
| Total liabilities and equity                                                                                                                                  |       | $                  | 1,292,965  |                  | $          | 1,377,236 |   |

 

The accompanying notes arean integral part of these statements.

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF OPERATIONS**

(**UNAUDITED**)

 
| ** **                                                                              | ** ** | **Three  Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| **(Dollars in thousands - except per share)**                                           | ** ** | **2010**                                | ** ** | **2009** | ** ** |
| INTEREST INCOME                                                                         |       |                                    |       |   |   |
| Loans and leases, including fees                                                        |       | $                                       | 12,371     |   | $ | 13,209 |   |
| Investment securities                                                                   |       | 430                                     |       | 1,230 |   |
| Federal funds sold and deposits in banks                                                |       | 121                                     |       | 23 |   |
| Total interest income                                                                   |       | 12,922                                  |       | 14,462 |   |
|                                                                                    |       |                                    |       |   |   |
| INTEREST EXPENSE                                                                        |       |                                    |       |   |   |
| Deposits                                                                                |       | 2,941                                   |       | 3,868 |   |
| Subordinated debt                                                                       |       | 271                                     |       | 174 |   |
| Federal Home Loan Bank and other borrowings                                             |       | 1,435                                   |       | 1,459 |   |
| Total interest expense                                                                  |       | 4,647                                   |       | 5,501 |   |
|                                                                                    |       |                                    |       |   |   |
| Net interest income                                                                     |       | 8,275                                   |       | 8,961 |   |
|                                                                                    |       |                                    |       |   |   |
| Provision for loan and lease losses                                                     |       | 266                                     |       | 1,387 |   |
| Net interest income after provision for loan  and lease losses                |       | 8,009                                   |       | 7,574 |   |
|                                                                                    |       |                                    |       |   |   |
| NON-INTEREST INCOME                                                                     |       |                                    |       |   |   |
| Wealth management and advisory services                                                 |       | 888                                     |       | 918 |   |
| Service charges on deposit accounts                                                     |       | 586                                     |       | 632 |   |
| Losses on sales of investment securities, net                                           |       | —                                  |       | (88 | ) |
| Operating lease rental income                                                           |       | 257                                     |       | 340 |   |
| Net (loss) gains on sales of fixed assets and OREO                                      |       | (48                                     | )          | 46 |   |
| Bank owned life insurance                                                               |       | 18                                      |       | 13 |   |
| Write-down of other real estate owned                                                   |       | (1,333                                  | )          | — |   |
| Other                                                                                   |       | 645                                     |       | 533 |   |
|                                                                                    |       |                                    |       |   |   |
| Total non-interest income                                                               |       | 1,013                                   |       | 2,394 |   |
|                                                                                    |       |                                    |       |   |   |
| NON-INTEREST EXPENSE                                                                    |       |                                    |       |   |   |
| Salaries and employee benefits                                                          |       | 3,582                                   |       | 5,233 |   |
| Occupancy, equipment and data processing                                                |       | 1,753                                   |       | 1,776 |   |
| Depreciation expense on operating leases                                                |       | 208                                     |       | 280 |   |
| FDIC deposit insurance                                                                  |       | 670                                     |       | 413 |   |
| Bank shares tax                                                                         |       | 239                                     |       | 234 |   |
| Professional services                                                                   |       | 1,814                                   |       | 576 |   |
| Marketing                                                                               |       | 225                                     |       | 174 |   |
| Other real estate expense                                                               |       | 61                                      |       | 5 |   |
| Communications expense                                                                  |       | 191                                     |       | 211 |   |
| Other                                                                                   |       | 883                                     |       | 866 |   |
|                                                                                    |       |                                    |       |   |   |
| Total non-interest expense                                                              |       | 9,626                                   |       | 9,768 |   |
|                                                                                    |       |                                    |       |   |   |
| (Loss) income from continuing operations before  income taxes                           |       | (604                                    | )          | 200 |   |
|                                                                                    |       |                                    |       |   |   |
| INCOME TAXES                                                                            |       | —                                  |       | 61 |   |
|                                                                                    |       |                                    |       |   |   |
| NET (LOSS) INCOME FROM CONTINUING OPERATIONS                                            |       | $                                       | (604       | ) | $ | 139 |   |
|                                                                                    |       |                                    |       |   |   |
| DISCONTINUED OPERATIONS:                                                                |       |                                    |       |   |   |
| (Loss) income from discontinued operations, net of  taxes of $0 and $1,210 (see Note 6) |       | (999                                    | )          | 3,349 |   |
| Less: Net income attributable to non-controlling interest                               |       | 198                                     |       | 168 |   |
| Net (loss) income attributable to discontinued  operations                              |       | (1,197                                  | )          | 3,181 |   |
|                                                                                    |       |                                    |       |   |   |
| NET (LOSS) INCOME ATTRIBUTABLE TO FIRST CHESTER  COUNTY CORPORATION                     |       | $                                       | (1,801     | ) | $ | 3,320 |   |
|                                                                                    |       |                                    |       |   |   |
| PER SHARE DATA                                                                          |       |                                    |       |   |   |
| Net (loss) income per share from continuing  operations (Basic)                         |       | $                                       | (0.10      | ) | $ | 0.02 |   |
| Net (loss) income per share from continuing  operations (Diluted)                       |       | $                                       | (0.10      | ) | $ | 0.02 |   |
|                                                                                    |       |                                    |       |   |   |
| Net (loss) income per share from discontinued  operations (Basic)                       |       | $                                       | (0.19      | ) | $ | 0.51 |   |
| Net (loss) income per share from discontinued  operations (Diluted)                     |       | $                                       | (0.19      | ) | $ | 0.51 |   |
|                                                                                    |       |                                    |       |   |   |
| Net (loss) income per share attributable to First  Chester County Corporation (Basic)   |       | $                                       | (0.28      | ) | $ | 0.53 |   |
| Net (loss) income per share attributable to First  Chester County Corporation (Diluted) |       | $                                       | (0.28      | ) | $ | 0.53 |   |
|                                                                                    |       |                                    |       |   |   |
| Dividends declared                                                                      |       | $                                       | —     |   | $ | 0.14 |   |
|                                                                                    |       |                                    |       |   |   |
| Basic weighted average shares outstanding                                               |       | 6,336,434                               |       | 6,242,252 |   |
| Diluted weighted average shares outstanding                                             |       | 6,336,434                               |       | 6,242,252 |   |

 

The accompanying notes arean integral part of these statements.

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASHFLOWS**

(**UNAUDITED**)

 
| ** **                                                                                          | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| **(Dollars  in thousands)**                                                                         | ** ** | **2010**                          | ** ** | **2009** | ** ** |
| OPERATING ACTIVITIES                                                                                |       |                              |       |   |   |
| Net (loss) income attributable to First Chester  County Corporation                                 |       | $                                 | (1,801     | ) | $ | 3,320 |   |
| Net income attributable to non-controlling  interest                                                |       | 198                               |       | 168 |   |
| Net (loss) income including non-controlling  interest                                               |       | $                                 | (1,603     | ) | $ | 3,488 |   |
| Adjustments to reconcile net (loss) income to net  cash provided by (used in) operating activities: |       |                              |       |   |   |
| Depreciation                                                                                        |       | 857                               |       | 904 |   |
| Provision for loan and lease losses                                                                 |       | 266                               |       | 1,387 |   |
| Amortization of investment security premiums and  accretion of discounts, net                       |       | 141                               |       | 78 |   |
| Amortization of deferred loan fees                                                                  |       | (717                              | )          | 28 |   |
| Losses on sales of investment securities available  for sale, net                                   |       | —                            |       | 88 |   |
| Net loss (gain) from sale of fixed assets and OREO                                                  |       | 48                                |       | (46 | ) |
| Write-down of other real estate owned                                                               |       | 1,333                             |       | — |   |
| Net gain from mortgage banking activities                                                           |       | (9,891                            | )          | (11,966 | ) |
| Proceeds from the sale of mortgage loans held for  sale                                             |       | 479,207                           |       | 527,376 |   |
| Origination of mortgage loans held for sale                                                         |       | (369,836                          | )          | (602,845 | ) |
| Net cash paid for the settlement of derivative  contracts                                           |       | (129                              | )          | (981 | ) |
| Stock-based compensation expense                                                                    |       | 36                                |       | 41 |   |
| Decrease (increase) in other assets                                                                 |       | 8,223                             |       | (1,378 | ) |
| (Decrease) increase in other liabilities                                                            |       | (2,136                            | )          | 5,704 |   |
|                                                                                                |       |                              |       |   |   |
| Net cash provided by (used in) operating  activities                                                |       | 105,799                           |       | (78,122 | ) |
|                                                                                                |       |                              |       |   |   |
| INVESTING ACTIVITIES                                                                                |       |                              |       |   |   |
| Net decrease (increase) in loans                                                                    |       | 17,318                            |       | (535 | ) |
| Proceeds from sales of investment securities  available-for-sale                                    |       | —                            |       | 11,807 |   |
| Proceeds from maturities prepayments and calls of  investment securities available-for-sale         |       | 18,807                            |       | 2,952 |   |
| Purchases of investment securities  available-for-sale                                              |       | (745                              | )          | (731 | ) |
| Proceeds from the sale of OREO                                                                      |       | 476                               |       | — |   |
| Purchase of premises and equipment                                                                  |       | (13                               | )          | (2,447 | ) |
| Proceeds from the sale of premises and equipment                                                    |       | 37                                |       | — |   |
|                                                                                                |       |                              |       |   |   |
| Net cash provided by investing activities                                                           |       | 35,880                            |       | 11,046 |   |
|                                                                                                |       |                              |       |   |   |
| FINANCING ACTIVITIES                                                                                |       |                              |       |   |   |
| Change in subsidiary’s shares from non-controlling  interest                                   |       | (637                              | )          | 45 |   |
| Decrease in short term Federal Home Loan Bank and  other short term borrowings                      |       | —                            |       | (1,000 | ) |
| Increase in long term Federal Home Loan Bank and  other borrowings                                  |       | —                            |       | 15,000 |   |
| Repayment of long term Federal Home Loan Bank and  other borrowings                                 |       | (42,643                           | )          | (20,172 | ) |
| Net (decrease) increase in deposits                                                                 |       | (37,460                           | )          | 34,131 |   |
| Cash dividends paid                                                                                 |       | —                            |       | (900 | ) |
| Net treasury stock transactions                                                                     |       | (158                              | )          | 65 |   |
|                                                                                                |       |                              |       |   |   |
| Net cash (used in) provided by financing  activities                                                |       | (80,898                           | )          | 27,169 |   |
|                                                                                                |       |                              |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                               |       | 60,781                            |       | (39,907 | ) |
|                                                                                                |       |                              |       |   |   |
| Cash and cash equivalents at beginning of period                                                    |       | 146,681                           |       | 95,150 |   |
|                                                                                                |       |                              |       |   |   |
| Cash and cash equivalents at end of period                                                          |       | $                                 | 207,462    |   | $ | 55,243 |   |
|                                                                                                |       |                              |       |   |   |
| Supplementary cash flow information:                                                                |       |                              |       |   |   |
| Interest paid                                                                                       |       | $                                 | 5,415      |   | $ | 6,300 |   |
| Income taxes paid                                                                                   |       | $                                 | —     |   | $ | 50 |   |
| Loans transferred to other real estate owned                                                        |       | $                                 | 1,137      |   | $ | 322 |   |

 

The accompanying notes are an integral part of these statements.

 

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**FIRST CHESTER COUNTYCORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENT OF CHANGES IN EQUITY**

(**UNAUDITED**)

 
| ** **                                                              | ** ** | **Common Stock** | ** ** | **Additional  Paid -in** | ** ** | **Retained** | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Treasury**      | ** ** | **Non-  Controlling** | ** ** | **Total**    | ** ** | **Comprehensive** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------|------------|-------------------------------|------------|--------------|------------|---------------------------------------|------------|-------------------|------------|-----------------------|------------|--------------|------------|-------------------|------------|
| **(Dollars in thousands)**                                    | ** ** | **Shares**            | ** ** | **Par Value**            | ** ** | **Capital**  | ** ** | **Earnings**                          | ** ** | **Income/(loss)** | ** ** | **Stock**             | ** ** | **Interest** | ** ** | **Equity**        | ** ** | **Income** | ** ** |
|                                                                    |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       |   |   |
| Balance  January 1, 2009                                           |       | 6,331,975             |       | $                             | 6,332      |         | $          | 24,708                                |       | $                 | 57,899     |                  | $          | (3,292       | )          | $                 | (1,815     | ) | $ | 1,485 |   | $ | 85,317 |   |   |   |
|                                                                    |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       |   |   |
| Cumulative  effect adjustment under ASC 860-50                     |       | —                |       | —                        |       | —       |       | 240                                   |       | —            |       | —                |       | —       |       | 240               |       |   |   |
| Balance  January 1, 2009, as adjusted                              |       | 6,331,975             |       | 6,332                         |       | 24,708       |       | 58,139                                |       | (3,292            | )          | (1,815                | )          | 1,485        |       | 85,557            |       |   |   |
|                                                                    |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       |   |   |
| Change  in subsidiary shares from non-controlling interest              |       | —                |       | —                        |       | —       |       | —                                |       | —            |       | —                |       | (123         | )          | (123              | )          |   |   |
| Net  income                                                             |       | —                |       | —                        |       | —       |       | 3,320                                 |       | —            |       | —                |       | 168          |       | 3,488             |       | 3,488 |   |
| Cash  dividends declared                                                |       | —                |       | —                        |       | —       |       | (875                                  | )          | —            |       | —                |       | —       |       | (875              | )          |   |   |
| Other  comprehensive income                                             |       | —                |       | —                        |       | —       |       | —                                |       | —            |       | —                |       | —       |       | —            |       |   |   |
| Net  unrealized losses on investment securities available-for-sale |       | —                |       | —                        |       | —       |       | —                                |       | (404              | )          | —                |       | —       |       | (404              | )          | (404 | ) |
| Treasury  stock transactions                                            |       | —                |       | —                        |       | (153         | )          | —                                |       | —            |       | 218                   |       | —       |       | 65                |       | — |   |
| Stock  based compensation                                               |       | —                |       | —                        |       | 41           |       | —                                |       | —            |       | —                |       | —       |       | 41                |       | — |   |
| Total  comprehensive income                                             |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       | $ | 3,084 |   |
|                                                                    |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       |   |   |
| Balance  March 31, 2009                                            |       | 6,331,975             |       | $                             | 6,332      |         | $          | 24,596                                |       | $                 | 60,584     |                  | $          | (3,696       | )          | $                 | (1,597     | ) | $ | 1,530 |   | $ | 87,749 |   |   |   |
|                                                                    |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       |   |   |
| Balance  January 1, 2010                                           |       | 6,354,475             |       | 6,354                         |       | 23,678       |       | 25,753                                |       | (499              | )          | (209                  | )          | 1,825        |       | 56,902            |       |   |   |
|                                                                    |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       |   |   |
| Change  in subsidiary shares from non-controlling interest              |       | —                |       | —                        |       | —       |       | —                                |       | —            |       | —                |       | (835         | )          | (835              | )          |   |   |
| Net  (loss) income                                                      |       | —                |       | —                        |       | —       |       | (1,801                                | )          | —            |       | —                |       | 198          |       | (1,603            | )          | (1,603 | ) |
| Other  comprehensive income                                             |       | —                |       | —                        |       | —       |       | —                                |       | —            |       | —                |       | —       |       | —            |       |   |   |
| Net  unrealized gains on investment securities Available-for-sale  |       | —                |       | —                        |       | —       |       | —                                |       | 528               |       |                  |       | —       |       | 528               |       | 528 |   |
| Treasury  stock transactions                                            |       | —                |       | —                        |       | —       |       | —                                |       | —            |       | (157                  | )          | —       |       | (157              | )          |   |   |
| Share  based compensation                                               |       | —                |       | —                        |       | 36           |       | —                                |       | —            |       | —                |       | —       |       | 36                |       |   |   |
| Total  comprehensive loss                                               |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       | $ | (1,075 | ) |
|                                                                    |       |                  |       |                          |       |         |       |                                  |       |              |       |                  |       |         |       |              |       |   |   |
| Balance  March 31, 2010                                            |       | 6,354,475             |       | $                             | 6,354      |         | $          | 23,714                                |       | $                 | 23,952     |                  | $          | 29           |       | $                 | (366       | ) | $ | 1,188 |   | $ | 54,871 |   |   |   |

 

The accompanying notes are an integral part of these statements.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**1.****           ****Summaryof Significant Accounting Policies**

 

**Basis of presentation**

 

Theforegoing unaudited financial statements have been prepared in accordance withaccounting principles generally accepted in the United States (“GAAP”) forinterim financial information.  Thepreparation of the financial statements in conformity with GAAP requiresmanagement to make estimates and assumptions that affect the amounts reportedin the financial statements and the accompanying notes.  Actual results could differ from thoseestimates.

 

Inthe opinion of management, all adjustments (consisting only of normal recurringadjustments) necessary for a fair presentation of the financial position andthe results of operations for the interim period presented have beenincluded.  The results of operations forthe three month period ended March 31, 2010 are not necessarily indicative ofthe results to be expected for the full year. Therefore, these interim financial statements should be read inconjunction with the consolidated financial statements and footnotes theretoincluded in our Annual Report on Form 10-K for the year endedDecember 31, 2009 (our “2009 Annual Report”).

 

Priorto January 1, 2010, our business was conducted through two primary segments,community banking and mortgage banking.  During the first quarter 2010, weannounced the potential sale of our American Home Bank (“AHB”) mortgage bankingsegment.  Accordingly, the mortgagebanking operations related to this segment have been reclassified, and are nowpresented as discontinued operations in the consolidated statements ofoperations.  Certain assets and liabilities of this former segment arepresented as discontinued assets held for sale. The statements of cash flows are presented on a consolidated basis,including both continuing and discontinued operations.  The notes to the consolidated financialstatements have been adjusted to exclude discontinued operations unlessotherwise noted.  Footnote segment disclosures are not and will no longerbe provided.  Refer to Note 6 of theaccompanying consolidated financial statements for information related todiscontinued operations.

 

The consolidated financial statements include theaccounts of First Chester County Corporation (“First Chester” or “Corporation”)  and First National Bank of Chester County(the “Bank”).  All material intercompanybalances and transactions have been eliminated in consolidation.

 

**2.****             ****GoingConcern**

 

TheCorporation’s financial statements have been prepared on a going concern basis,which contemplates the realization of assets and the discharge of liabilitiesin the normal course of business for the foreseeable future. However, due tothe Corporation’s financial results, the substantial uncertainty throughout theU.S. banking industry and other matters discussed in this report, a substantialdoubt exists regarding our ability to continue as a going concern. Ourfinancial statements do not include any adjustments that might be necessary ifwe are unable to continue as a going concern.

 

Asfurther described in Note 5, on October 16, 2009, the Bank entered into aMemorandum of Understanding (“MOU”) with the Office of the Comptroller of theCurrency (“OCC”). The OCC also mandated higher individual minimum capitalratios (“IMCRs”), which the Bank was required to achieve by December 31, 2009.Continued operations may depend on the Corporation’s ability to comply with theterms of the MOU, the IMCRs and the closing of the pending merger with TowerBancorp, Inc. (“Tower”). For the year ended December 31, 2009, the Corporationhas incurred a net loss from operations, primarily from the higher provisionsfor loan losses due to increased levels of non-performing assets, the write-offof goodwill and the establishment of a valuation allowance on the deferred taxassets. Our efforts to raise capital to comply with the IMCRs prior to thedeadline ultimately resulted in the planned merger with Tower, as described inNote 3 below, which was announced on December 28, 2009. In addition, in effortsto conserve capital, we elected to reduce and subsequently suspend our cashdividends on our common stock beginning with the third quarter of 2009.However, despite the above efforts, as of March 31, 2010 and December 31, 2009,the Bank was below certain IMCR thresholds, as further discussed in Note 5.

 

Managementand the board of directors are committed to the planned merger with Tower.However, if the announced merger were not to occur, then Management would seekto recapitalize the Bank by finding another merger partner or by raisingadditional capital in the public or private markets. The Corporation iscompleting a

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(UNAUDITED)**

 

regularplanning cycle for 2011, which includes, among other things, updating theCorporation’s strategic business plan and creating detailed operating andmarketing plans for the Bank as an independent company.

 

**3.****           ****PendingMerger**

 

OnDecember 27, 2009, the Corporation entered into a definitive merger agreement,as amended on March 4, 2010 (the “Merger Agreement”), with Tower, the holdingcompany for Graystone Tower Bank (“Graystone”), pursuant to which First Chesterwill merge with and into Tower (the “Merger”), with Tower being the survivingcorporation. The Merger Agreement also provides that upon consummation of themerger, the Bank will merge with and into Graystone, with Graystone as thesurviving institution (the “Bank Merger”). The Merger Agreement additionallyprovides for the potential sale of the AHB segment at or prior to theconsummation of the Merger. At the effective time of the Merger, the board ofdirectors of Tower will be increased by three (3) directors and three (3) ofthe current directors of First Chester selected by the board of directors ofFirst Chester, with the approval of Tower’s board of directors, will be addedto the board of directors of Tower, to serve as such for no less than threeyears.

 

Underthe terms of the Merger Agreement, shareholders of First Chester will receive0.453 shares of Tower common stock for each share of First Chester common stockthey own. The Merger Agreement establishes loan delinquency thresholds andprovides for an increase or reduction in the consideration paid by Tower toFirst Chester shareholders in the event of specified increases or decreases inFirst Chester’s loan delinquencies prior to closing.

 

Directorsand executive officers of First Chester have entered into Voting Agreementswith Tower, pursuant to which they have agreed, among other things, to vote allshares of common stock of First Chester owned by them in favor of the approvalof the Merger at the special shareholder’s meeting to vote upon the Merger.

 

Consummationof the Merger is subject to certain terms and conditions, including, but notlimited to, receipt of various regulatory approvals and approval by both Tower’sand First Chester’s shareholders and First Chester’s loan delinquencies notexceeding $90 million in the aggregate. As of June 30, 2010, all regulatoryapprovals have been received from the bank regulators. However, certain ofthese approvals contain expiration dates such that extensions may need to beobtained if the merger is not closed prior to the end of the third quarter of2010.

 

**4.****           ****RecentAccounting Pronouncements**

 

InJuly 2010, the FASB issued an update Accounting Standards Update (“ASU”) 2010-20,Receivables (Topic 310): Disclosures about the Credit Quality of FinancingReceivables and the Allowance for Credit Losses. The update requires companiesto provide more information in their disclosures about the credit quality oftheir financing receivables and the credit reserves held against them. Theamendments that require disclosures as of the end of a reporting period areeffective for the periods ending on or after December 15, 2010. ASU2010-20 will enhance the disclosure requirements for financing receivables andcredit losses, but will not impact the Corporation’s financial position,results of operations or cash flows.

 

In February 2010, the FASB issued ASU 2010-09,Subsequent Events (Topic 855): Amendments to Certain Recognition and DisclosureRequirements.  This guidance removes the requirement for a Securitiesand Exchange Commission (“SEC”) filer to disclose a date through whichsubsequent events have been evaluated in both issued and revised financialstatements. Revised financial statements include financial statements revisedas a result of either correction of an error or retrospective application ofGAAP.  ASU 2010-09 is intended to remove potential conflicts with the SEC’sliterature and all of the amendments are effective upon issuance, exceptfor the use of the issued date for conduit debt obligors, which will beeffective for interim or annual periods ending after June 15, 2010.

 

In January 2010, the FASB issued ASU 2010-06,Fair Value Measurements and Disclosures (Topic 820): Improving Disclosuresabout Fair Value Measurements.  This guidance requires:(1) disclosure of the significant amount transferred in and out of Level 1and Level 2 fair value measurements and the reasons for the transfers; and(2) separate presentation of purchases, sales, issuances and settlementsin the reconciliation for fair value measurements using significantunobservable inputs (Level 3). In addition, ASU 2010-06 clarifies the

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

requirements of the following existing disclosuresset forth in FASB Accounting Standards Codifications (ASC) 820, “Fair ValueMeasurements and Disclosures”: (1) For purposes of reporting fair valuemeasurement for each class of assets and liabilities, a reporting entity needsto use judgment in determining the appropriate classes of assets andliabilities; and (2) a reporting entity should provide disclosures aboutthe valuation techniques and inputs used to measure fair value for bothrecurring and nonrecurring fair value measurements. This guidance is effectivefor interim and annual reporting periods beginning January 1, 2010, exceptfor the disclosures about purchases, sales, issuances, and settlements in theroll forward of activity in Level 3 fair value measurements, which areeffective for fiscal years beginning January 1, 2011, and for interimperiods within those fiscal years. The Corporation adopted the guidance on January1, 2010, and the guidance did not have an impact on the Corporation’s financialcondition or results of operations.

 

In June 2009, the FASB updated ASC 860, “Transfersand Servicing,” to eliminate the concept of a qualifying special-purpose entity(“QSPE”), modify the criteria for applying sale accounting to transfers offinancial assets or portions of financial assets, differentiate between theinitial measurement of an interest held in connection with the transfer of anentire financial asset recognized as a sale and participating interestsrecognized as a sale and remove the provision allowing classification ofinterests received in a guaranteed mortgage securitization transaction thatdoes not qualify as a sale as available-for-sale or trading securities. Theupdates to ASC 860 clarify (i) that an entity must consider allarrangements or agreements made contemporaneously or in contemplation of atransfer, (ii) the isolation analysis related to the transferor and itsconsolidated subsidiaries and (iii) the principle of effective controlover the transferred financial asset. The updates to ASC 860 also enhancefinancial statement disclosures. The updates to ASC 860 are effective forfiscal years beginning after November 15, 2009 with earlier applicationprohibited. Revised recognition and measurement provisions are to be applied totransfers occurring on or after the effective date and the disclosureprovisions are to be applied to transfers that occurred both before and afterthe effective date. The guidance was effective for January 1, 2010 and did nothave an impact on the Corporation’s financial condition or results ofoperations.

 

In June 2009, the FASB updated ASC 810, “Consolidation,”to modify certain characteristics that identify a variable interest entity (“VIE”),revise the criteria for determining the primary beneficiary of a VIE, add anadditional reconsideration event to determining whether an entity is a VIE,eliminating troubled debt restructurings as an excluded reconsideration eventand enhance disclosures regarding involvement with a VIE. Additionally, withthe elimination of the concept of QSPEs in the updates to ASC 860, entitiespreviously considered QSPEs are now within the scope of ASC 810. Entitiesrequired to consolidate or deconsolidate a VIE will recognize a cumulativeeffect in retained earnings for any difference in the carrying amount of theinterest recognized. The updates to ASC 810 are effective for fiscal yearsbeginning after November 15, 2009 with earlier application prohibited. Theguidance was effective for January 1, 2010 and did not have an impact on theCorporation’s financial condition or results of operations.

 

**5.****             ****RegulatoryMatters**

 

*Supervisory Actions*

 

TheBank is subject to various regulatory capital requirements administered by thefederal banking agencies. Failure to meet minimum capital requirements canprompt certain mandatory, and possibly additional discretionary, actions byregulators that, if undertaken, could have a direct material effect on theCorporation’s financial statements. Under capital adequacy guidelines and theregulatory framework for prompt corrective action, the Bank must meet specificcapital guidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance-sheet items as calculated under regulatoryaccounting practices. The Bank’s capital amounts and classification are alsosubject to qualitative judgments by the regulators involving factors such asthe risk weights assigned to assets and what items may be counted as capital.Regulators also have broad discretion to require any institution to maintainhigher capital levels than otherwise required by statute or regulation, eveninstitutions that are considered “well-capitalized” under applicable regulations.

 

OnOctober 16, 2009, the Board of Directors of the Bank entered into an MOU withthe OCC. An MOU with regulatory authorities is an informal action that is notpublished or publicly available and that is used when circumstances warrant amilder form of action than a formal supervisory action, such as a formalwritten agreement or order. Under the MOU, the Bank has agreed to address,among other things, the following matters:

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

·                  Develop a comprehensive three-year capitalplan;

 

·                  Take action to protect criticized assets andadopt and implement a program to eliminate the basis of criticism of suchassets;

 

·                  Establish an effective program that providesfor early problem loan identification and a formal plan to proactively managethose assets;

 

·                  Review the adequacy of the Bank’s informationtechnology activities and Bank Secrecy Act compliance and approve writtenprograms of policies and procedures to provide for compliance; and

 

·                  Establish a Compliance Committee of the Boardto monitor and coordinate the Bank’s adherence to the provisions of the MOU.

 

TheBoard of Directors and Management have initiated corrective actions to complywith the provisions of the MOU.

 

Additionally,in November 2009, the Bank was advised that the OCC established IMCRs for theBank higher than the capital ratios generally applicable to banks under currentregulations. In the case of the Bank, the OCC established IMCRs requiring aTier 1 leverage ratio of at least eight percent (8%), a Tier 1 risk-basedcapital ratio of at least ten percent (10%) and a total risk-based capitalratio of at least twelve percent (12%) which the Bank was required to achieveby December 31, 2009. The Corporation’s efforts to raise capital prior to thedeadline ultimately resulted in the planned merger with Tower Bancorp, whichwas announced on December 28, 2009. Additionally, during the fourth quarter of 2009, the Corporationreceived notice from the Federal Reserve, its primary regulator, that theFederal Reserve must approve any dividends to be paid in advance of thedeclaration or payment of the dividend.

 

Forthe purpose of satisfying the IMCRs, during December 2009, the Corporationentered into an amendment to our existing loan agreement with Graystone torecapitalize the Bank. As of December 31, 2009, the Corporation borrowed thefull $26.0 million available under the credit facility which was contributed tothe Bank as Tier 1 capital. Additionally, Graystone purchased $52.5 million infirst lien residential real estate and commercial loan participations at a 1.5%discount.

 

Asset forth below, as of March 31, 2010, the Bank met the IMCR thresholds forTier 1 risk-based capital and total risk-based capital, but was below the IMCRthreshold for Tier 1 leverage. The OCC may deem the Bank’s noncompliance to bean unsafe and unsound banking practice which may subject the Bank to a capitaldirective, a consent order, or such other administrative actions or sanctionsas the OCC considers necessary. It is uncertain what actions, if any, the OCCwould take with respect to noncompliance with these ratios, what action stepsthe OCC might require the Bank to take to remedy this situation, and whethersuch actions would be successful.

 

The Corporation’s and Bank’s actual capital levels and ratios arepresented below:

 
| ** **                     | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Individual Minimum  Capital Ratios** | ** ** |
|--------------------------------|------------|------------|------------|------------------------------------|------------|-----------------------------------------------------------------------|------------|
| **(Dollars  in thousands)**    | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                            | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As of March 31, 2010:          |       |       |       |                               |       |                                                                  |       |   |   |   |   |   |   |
| Leverage Ratio                 |       |       |       |                               |       |                                                                  |       |   |   |   |   |   |   |
| Corporation                    |       | 73,492     |       | 5.61                               | %          | 52,402                                                                |       | >4.00 | % | N/A |   | N/A |   |
| Bank                           |       | 100,896    |       | 7.71                               | %          | 52,319                                                                |       | >4.00 | % | 104,638 |   | >8.00 | % |
| Tier I Capital Ratio           |       |       |       |                               |       |                                                                  |       |   |   |   |   |   |   |
| Corporation                    |       | 73,492     |       | 8.15                               | %          | 36,080                                                                |       | >4.00 | % | N/A |   | N/A |   |
| Bank                           |       | 100,896    |       | 11.22                              | %          | 35,984                                                                |       | >4.00 | % | 89,960 |   | >10.00 | % |
| Total Risk Based Capital Ratio |       |       |       |                               |       |                                                                  |       |   |   |   |   |   |   |
| Corporation                    |       | 87,009     |       | 9.65                               | %          | 72,159                                                                |       | >8.00 | % | N/A |   | N/A |   |
| Bank                           |       | 112,314    |       | 12.48                              | %          | 71,968                                                                |       | >8.00 | % | 107,952 |   | >12.00 | % |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 
| ** **                     | ** ** | **Actual** | ** ** | **For Capital  Adequacy Purposes** | ** ** | **To Be Well  Capitalized Under  Individual Minimum  Capital Ratios** | ** ** |
|--------------------------------|------------|------------|------------|------------------------------------|------------|-----------------------------------------------------------------------|------------|
| **(Dollars  in thousands)**    | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                            | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| As of December 31, 2009:       |       |       |       |                               |       |                                                                  |       |   |   |   |   |   |   |
| Leverage Ratio                 |       |       |       |                               |       |                                                                  |       |   |   |   |   |   |   |
| Corporation                    |       | 76,459     |       | 5.71                               | %          | 53,522                                                                |       | >4.00 | % | N/A |   | N/A |   |
| Bank                           |       | 102,617    |       | 7.68                               | %          | 53,472                                                                |       | >4.00 | % | 106,943 |   | >8.00 | % |
| Tier I Capital Ratio           |       |       |       |                               |       |                                                                  |       |   |   |   |   |   |   |
| Corporation                    |       | 76,459     |       | 7.79                               | %          | 39,262                                                                |       | >4.00 | % | N/A |   | N/A |   |
| Bank                           |       | 102,617    |       | 10.47                              | %          | 39,203                                                                |       | >4.00 | % | 98,008 |   | >10.00 | % |
| Total Risk Based Capital Ratio |       |       |       |                               |       |                                                                  |       |   |   |   |   |   |   |
| Corporation                    |       | 89,936     |       | 9.16                               | %          | 78,525                                                                |       | >8.00 | % | N/A |   | N/A |   |
| Bank                           |       | 115,035    |       | 11.74                              | %          | 78,407                                                                |       | >8.00 | % | 117,610 |   | >12.00 | % |

 

Dividend Restrictions

 

TheBank, as a national bank, is required by federal law to obtain the approval ofthe OCC for the payment of dividends if the total of all dividends declared bythe Board of Directors of the Bank in any calendar year will exceed the totalof the Bank’s net income for that year and the retained net income for thepreceding two years, less any required transfers to surplus or a fund for theretirement of any preferred stock, subject to the further limitations that anational bank can pay dividends only to the extent that the payment of suchdividends would not cause the Bank to become “undercapitalized” (as definedunder federal law).  There were nodividends declared or payable by the Bank as of March 31, 2010.

 

Duringthe fourth quarter of 2009, the Corporation received notice from the FederalReserve Board that the Federal Reserve must approve any dividends to be paid bythe Corporation in advance of the declaration or payment of the dividend.  The Corporation announced during the firstquarter 2010 that it will not be paying any dividends prior to the completionof the proposed merger. There were no dividends declared or payable by theCorporation as of March 31, 2010.

 

**6.****           ****DiscontinuedAssets Held for Sale and Discontinued Operations**

 

OnMarch 4, 2010, the Corporation and Tower, entered into an amendment to theMerger Agreement, which provides for the merger of the Bank with and intoGraystone, with Graystone as the surviving institution (the “Bank Merger”).Graystone and the Bank entered into a Bank Plan of Merger on March 4, 2010. Theamendment additionally provides for the potential sale of the AHB division ator prior to the consummation of the Merger. The Corporation has engaged a financial advisor to assist in the sale ofthe AHB division.

 

Theresults of operations of a component of an entity that has either been disposedof, or is classified as held for sale, shall be reported in discontinuedoperations if both the operations and cash flows of the component have been, orwill be, eliminated from ongoing operations of the entity as a result of thedisposal transaction and the entity will not have any significant continuinginvolvement in the operations of the component after the disposal transaction.

 

Indetermining whether the Corporation met the conditions for a qualified plan ofsale, management considered the relevant accounting guidance and concluded thatthe “held for sale” conditions were met during the first

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

quarter2010. Management determined that the Corporation will exit significant mortgagebanking activities after the sale of AHB and, as such, certain assets andliabilities of the Corporation’s mortgage banking operations will be presentedas discontinued assets held for sale and the results of operations directlyrelated to mortgage banking activity will be presented as discontinuedoperations for the quarter ended March 31, 2010 and for all future periods.

 

Loans held for sale and related derivative instruments are shown as aseparate disposal group separate from other AHB assets.  Based on interested third parties to date,management anticipates that these assets, although discontinued from theCorporation’s future business model most likely will not be sold in thetransaction as described above.  Theseassets although directly related to the mortgage banking segment’s operationsare to be sold by the Corporation shortly after the close of a potential saletransaction with the resulting cash remaining with the Corporation.  The Corporation does not expect to originatesignificant loans held for sale after the completion of the sale of itsmortgage banking operations.

 

Theremaining assets, disposal group 2, will likely be sold as indicated in theamended Merger Agreement noted above. The carrying value of these assets arerequired to be at the lower of their carrying value or fair market value, lesscosts to sell, and depreciation and amortization expense associated with assetsheld-for-sale ceases.  

 
| ** **                               | ** ** | **March 31,** | ** **  | **December 31,** | ** ** |
|------------------------------------------|------------|---------------|-------------|------------------|------------|
| ** **                               | ** ** | **2010**      | ** **  | **2009**         | ** ** |
| Disposal Group 1                         |       |          |        |             |       |
| Loans held for sale, at fair value       |       | $             | 103,277     |             | $          | 202,757 |   |
| Derivative instruments, at fair value    |       | 3,034         |        | 2,393            |       |
| Total assets                             |       | $             | 106,311     |             | $          | 205,150 |   |
|                                     |       |          |        |             |       |
| Disposal Group 2                         |       |          |        |             |       |
| Premises and equipment                   |       | 1,842         |        | 1,956            |       |
| Other miscellaneous assets               |       | 1,419         |        | 1,247            |       |
| Total assets                             |       | $             | 3,261       |             | $          | 3,203 |   |
|                                     |       |          |        |             |       |
| Accounts payable and accrued liabilities |       | $             |  3,174 |             | $          |  3,245 |   |
| Total liabilities                        |       | $             |  3,174 |             | $          |  3,245 |   |

 

Resultsof operations for discontinued operations for the three months ended March 31,2010 and 2009 are presented below.

 
| ** **                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                 | ** ** | **2010**                          | ** ** | **2009** | ** ** |
| Interest income (1)                                        |       | $                                 | 1,195      |   | $ | 1,845 |   |
| Interest expense (2)                                       |       | 348                               |       | 680 |   |
| Net interest income                                        |       | 847                               |       | 1,165 |   |
| Non-interest income                                        |       | 10,193                            |       | 12,962 |   |
| Non-interest expense (3)                                   |       | 12,039                            |       | 9,314 |   |
| Income (loss) before income taxes                          |       | (999                              | )          | 4,813 |   |
| Income taxes                                               |       | —                            |       | 1,464 |   |
| Net (loss) income prior to non-controlling  interest       |       | $                                 | (999       | ) | $ | 3,349 |   |
| Less: Net income attributable to non-controlling  interest |       | $                                 | 198        |   | $ | 168 |   |
| Loss from discontinued operations, net of taxes            |       | $                                 | (1,197     | ) | $ | 3,181 |   |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

** **

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

----

(1)          Interest income excludesinterest income earned on the Corporation’s residential and construction loansheld for investment that was previously disclosed as part of the results ofoperations of the mortgage banking segment. Management anticipates that these held for investment portfolios willremain as part of the Corporation’s continuing community banking operationsafter the sale of the mortgage banking business.

 

(2)          Interest expense of themortgage banking segment is based on management’s internal methodology ofallocating consolidated interest expense of the Corporation’s existing fundingsources to the mortgage banking segment’s assets directly related todiscontinued loans held for sale and certain discontinued non-interest earningassets held for sale.  This allocationmethodology is consistent with management’s previous segment reportingpolicies, however, it excludes any funding costs attributable to theCorporation’s residential and construction loans held for investment that werepreviously disclosed as part of the results of operations of the mortgagebanking segment.  Imputed interestexpense of the mortgage banking segment is shown as part of the consolidatedstatement of operations as deposit and Federal Home Loan Bank (“FHLB”) advancesand other borrowings interest expense. To properly report the net loss (income) from discontinued operations,interest expense from deposits of $318 thousand and $603 thousand and interestexpense from FHLB advances and other borrowings of $30 thousand and $77thousand for the periods ending March 31, 2010 and 2009, respectively, wasreclassified from the Corporation’s continuing operations on the consolidatedstatements of operations to interest expense from discontinued operations.

 

(3)          Non-interest expenseincludes a $500 thousand expense accrual resulting from anticipated investmentbanking, legal and audit fees directly related to the potential sale of AHB.

 

**7.****           ****InvestmentSecurities**

 

The Corporation’s investmentportfolio consists of the following categories of securities:

 

·                  US Treasury - Consists ofdebt securities issued by the US Government.

 

·                  US GovernmentAgency Notes - Consists of debt instruments issued by USGovernment agencies such as the Federal Home Loan Bank and Freddie Mac.

 

·                  US GovernmentAgency Mortgage Backed Securities - Consists of residentialmortgage pass-through securities and collateralized mortgage obligations “CMOs”issued by US government agencies such as GNMA, FNMA and Freddie Mac. The GNMApass-through securities or the underlying GNMA securities backing the CMOs areguaranteed by the US Government, while the FNMA and Freddie Mac pass-throughsecurities or the underlying FNMA and Freddie Mac securities backing the CMOsare guaranteed by the respective US Government agency.

 

·                  CollateralizedMortgage Obligations - Residential — Consists of private labelCMOs backed by non-government agency residential mortgage pools.

 

·                  CollateralizedMortgage Obligations - Commercial — Consists of private labelCMOs backed by non-government agency commercial mortgage pools.

 

·                  State andMunicipal— Consists of securities issued by state, city orlocal governments.

 

·                  Corporate DebtSecurities — Consists of corporate debt securities.

 

·                  Bank EquitySecurities — Consists of equity securities of banks, bankholding companies or bank trust preferred securities.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

** **

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

·                  Other EquitySecurities — Consists primarily of equity securities of theFederal Reserve and the Federal Home Loan Bank.

 

The amortized cost, grossunrealized gains and losses, and fair market value of the Corporation’savailable-for-sale securities at March 31, 2010 and December 31, 2009are summarized as follows:

 

March 31,2010

 
| ** **                                        | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                                        | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| **(Dollars  in thousands)**                       | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
|                                              |       |          |       |           |       |           |       |       |       |
| US Treasury                                       |       | $             | 5,002      |           | $          | 18             |       | $          | —     |   | $ | 5,020 |   |
| US Government agency notes                        |       | 2,022         |       | 6              |       | —         |       | 2,028      |       |
| US Government agency mortgage-backed securities   |       | 33,122        |       | 1,090          |       | (67            | )          | 34,145     |       |
| Collateralized mortgage obligations - Residential |       | 1,185         |       | 3              |       | (229           | )          | 959        |       |
| Collateralized mortgage obligations - Commercial  |       | 1,003         |       | —         |       | (178           | )          | 825        |       |
| State and municipal                               |       | 3,818         |       | 47             |       | —         |       | 3,865      |       |
| Corporate debt securities                         |       | 7,052         |       | —         |       | (693           | )          | 6,359      |       |
| Bank equity securities                            |       | 525           |       | 60             |       | (13            | )          | 572        |       |
| Other equity securities                           |       | 11,523        |       | —         |       | —         |       | 11,523     |       |
| Totals                                            |       | $             | 65,252     |           | $          | 1,224          |       | $          | (1,180     | ) | $ | 65,296 |   |

 

December 31,2009

 
| ** **                                        | ** ** | ** **    | ** ** | **Gross**      | ** ** | **Gross**      | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|---------------|------------|----------------|------------|----------------|------------|------------|------------|
| ** **                                        | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair**   | ** ** |
| **(Dollars  in thousands)**                       | ** ** | **Cost**      | ** ** | **Gains**      | ** ** | **Losses**     | ** ** | **Value**  | ** ** |
|                                              |       |          |       |           |       |           |       |       |       |
| US Treasury                                       |       | $             | 20,003     |           | $          | 13             |       | $          | —     |   | $ | 20,016 |   |
| US Government agency notes                        |       | 2,040         |       | 7              |       | —         |       | 2,047      |       |
| US Government agency mortgage-backed securities   |       | 36,193        |       | 902            |       | (100           | )          | 36,995     |       |
| Collateralized mortgage obligations - Residential |       | 1,249         |       | —         |       | (251           | )          | 998        |       |
| Collateralized mortgage obligations - Commercial  |       | 1,004         |       | —         |       | (196           | )          | 808        |       |
| State and municipal                               |       | 4,542         |       | 52             |       | —         |       | 4,594      |       |
| Corporate debt securities                         |       | 7,056         |       | —         |       | (1,191         | )          | 5,865      |       |
| Bank equity securities                            |       | 525           |       | 50             |       | (42            | )          | 533        |       |
| Other equity securities                           |       | 10,842        |       | —         |       | —         |       | 10,842     |       |
|                                              |       | $             | 83,454     |           | $          | 1,024          |       | $          | (1,780     | ) | $ | 82,698 |   |

 

The amortized cost and estimated fair value of debt securities classifiedas available-for-sale at March 31, 2010, by contractual maturity, areshown in the following table.  Expectedmaturities will differ from contractual maturities because borrowers may havethe right to call or prepay obligations with or without call or prepaymentpenalties.

 
| ** **                              | ** ** | **Amortized** | ** ** | **Fair**  | ** ** |
|-----------------------------------------|------------|---------------|------------|-----------|------------|
| **(Dollars  in thousands)**             | ** ** | **Cost**      | ** ** | **Value** | ** ** |
| Due in one year or less                 |       | $             | 5,951      |      | $          | 5,985 |   |
| Due after one year through five years   |       | 10,454        |       | 10,098    |       |
| Due after five years through ten years  |       | 500           |       | 502       |       |
| Due after ten years                     |       | 990           |       | 688       |       |
|                                    |       | 17,895        |       | 17,273    |       |
| Mortgage-backed securities and CMOs     |       | 35,310        |       | 35,928    |       |
| Bank equity and other equity securities |       | 12,047        |       | 12,095    |       |
|                                    |       | $             | 65,252     |      | $          | 65,296 |   |

 

Duringthe first quarter 2010 there were no sales of investment securities availablefor sale. Proceeds from the sale of investment securities available for salefor the three months ended March 31, 2009 were $11.8 million.  

 

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** **

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

Grosslosses from the sale of investment securities for the three months ended March 31,2009 were $88 thousand.  These securitieswere sold at fair values which approximated the Corporation’s amortizedcost.  The principal amount of investmentsecurities pledged to secure public deposits and for other purposes required orpermitted by law were $52.7 million at March 31, 2010 and $71.4 million atDecember 31, 2009. Other than US government agency mortgage backsecurities, there were no securities held from a single issuer that representedmore than 10% of stockholders’ equity.

 

The table below indicatesthe length of time individual securities have been in a continuous unrealizedloss position at March 31, 2010.

 
| ** **                                              | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total**      | ** ** |
|---------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|----------------|------------|
| **(Dollars  in thousands)  Description of**             | ** ** | **Number  of**          | ** ** | **Fair**                | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Securities**                                          | ** ** | **Securities**          | ** ** | **Value**               | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| US  Government agency mortgage-backed securities        |       | 4                       |       | $                       | 6,630      |           | $          | (67 | ) | $ | — |   | $ | — |   | $ | 6,630 |   | $ | (67 | ) |
|                                                    |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Collateralized  mortgage obligations — Residential |       | 2                       |       | —                  |       | —         |       | 680 |   | (229 | ) | 680 |   | (229 | ) |
| Collateralized  mortgage obligations — Commercial  |       | 1                       |       | —                  |       | —         |       | 825 |   | (179 | ) | 825 |   | (179 | ) |
|                                                    |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Corporate  debt securities                              |       | 6                       |       | —                  |       | —         |       | 6,359 |   | (692 | ) | 6,359 |   | (692 | ) |
|                                                    |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Bank  equity securities                                 |       | 2                       |       | —                  |       | —         |       | 242 |   | (13 | ) | 242 |   | (13 | ) |
|                                                    |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Total  temporarily impaired investment securities       |       | 15                      |       | $                       | 6,630      |           | $          | (67 | ) | $ | 8,106 |   | $ | (1,113 | ) | $ | 14,736 |   | $ | (1,180 | ) |

 

The table below indicates the length of time individual securities havebeen in a continuous unrealized loss position at December 31, 2009.

 
| ** **                                             | ** ** | **Less than 12 months** | ** ** | **12 months or longer** | ** ** | **Total**      | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|----------------|------------|
| **(Dollars  in thousands)**                            | ** ** | **Number**              | ** ** | ** **              | ** ** | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Description  of**                                    | ** ** | **of**                  | ** ** | **Fair**                | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| **Securities**                                         | ** ** | **Securities**          | ** ** | **Value**               | ** ** | **Losses**     | ** ** | **Value** | ** ** | **Losses** | ** ** | **Value** | ** ** | **Losses** | ** ** |
| US Government agency mortgage-backed securities        |       | 5                       |       | $                       | 9,386      |           | $          | (100 | ) | $ | — |   | $ | — |   | $ | 9,386 |   | $ | (100 | ) |
|                                                   |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Collateralized mortgage obligations — Residential |       | 3                       |       | 292                     |       | —         |       | 700 |   | (251 | ) | 992 |   | (251 | ) |
| Collateralized mortgage obligations — Commercial  |       | 1                       |       | —                  |       | —         |       | 808 |   | (196 | ) | 808 |   | (196 | ) |
|                                                   |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Corporate debt securities                              |       | 6                       |       | —                  |       | —         |       | 5,865 |   | (1,191 | ) | 5,865 |   | (1,191 | ) |
|                                                   |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Bank equity securities                                 |       | 2                       |       | —                  |       | —         |       | 213 |   | (42 | ) | 213 |   | (42 | ) |
|                                                   |       |                    |       |                    |       |           |       |   |   |   |   |   |   |   |   |
| Total temporarily impaired  investment securities |       | 17                      |       | $                       | 9,678      |           | $          | (100 | ) | $ | 7,586 |   | $ | (1,680 | ) | $ | 17,264 |   | $ | (1,780 | ) |

 

**Other than Temporary Impairment**

 

Inaccordance with ASC 320-10, “Investments — Debt and Equity Securities,” theCorporation evaluates its securities portfolio for other-than-temporaryimpairment (“OTTI”) throughout the year. Each investment, that

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

** **

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

hasa fair value less than the book value is reviewed on a quarterly basis bymanagement. Management considers at a minimum the following factors that, bothindividually or in combination, could indicate that the decline isother-than-temporary: (a) the Corporation has the intent to sell thesecurity; (b) it is more likely than not that it will be required to sellthe security before recovery; and (c) the Corporation does not expect torecover the entire amortized cost basis of the security.  Among thefactors that are considered in determining intent is a review of capitaladequacy, interest rate risk profile and liquidity at the Corporation. Animpairment charge is recorded against individual securities if the review describedabove concludes that the decline in value is other-than-temporary.  There were no impairments recorded during thefirst quarter of 2010 on available for sale securities.

 

Specificconclusions for each category of securities with an unrealized loss positionand where management believed an other than temporary impairment analysis waswarranted are summarized below:

 

*CMO — Residential andCommercial*

 

There are a total of threeprivate label CMO securities that had unrealized loss positions at March 31,2010. One of the securities had a AAA rating from S&P, one had an AA-rating from S&P, and the other had a B- rating from S&P. Allcontractual cash flows have been received on these securities. All of theseissuances have subordinated tranches supporting principal. In addition, weconducted due diligence of publicly available information regarding thesesecurities and no material information came to our attention that wouldindicate an inability to recover our basis in these securities. The depreciationon two of the securities accounted for 99% of the total depreciation withinthis category. For these securities, we reviewed and considered informationabout the underlying collateral as well as loss and prepayment stress testinformation performed by professional investment advisors. This informationindicated likelihood that subordinate tranches of the CMO provide sufficientprotection to the Bank’s senior tranches such that management can conclude thatthe probability of suffering a principal loss is unlikely. Because the Companydoes not intend to sell these securities and it is more likely than not thatthe Company will not be required to sell the securities before recovery of itsamortized cost basis, which may be maturity, it does not consider these investmentsto be other-than-temporarily impaired at March 31, 2010.

 

*Corporate Debt Securities*

 

There are a total of sixsecurities in this category that had unrealized loss positions atMarch 31, 2010. All of these securities are obligations of well-known,established companies or subsidiaries thereof. All contractual cash flows havebeen received on these securities. Depreciation on five of the securitiesaccounted for 99% of the total depreciation in this category. For these fivesecurities management reviewed rating agency information and noted that threesecurities had ratings below investment grade from Moody’s. We reviewed currentnews and filings as well as the length and duration of the depreciation andconcluded that there was no information that would indicate a going concern orother matter related to the issuer that would impair our ability to recover ourcost basis. Management performed additional analysis on the securities that werenot investment grade, which included reviewing analysis from our third partyinvestment advisor as well as current news and filings. The conclusion drawnfrom this information was that there was no information that indicated a goingconcern or other issue that would impair our ability to recover our cost basis.Because the Corporation does not intend to sell these securities and it is notmore likely than not that the Corporation will be required to sell thesecurities before recovery of its amortized cost basis, it does not considerthese investments to be other-than-temporarily impaired at March 31,2010.

 

**8.****             ****Loansand Leases**

 

Thefollowing tables present information about major loan classifications, as wellas impaired loans and lease balances as of March 31, 2010 andDecember 31, 2009:

 

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** **

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

March 31, 2010

 
| **(Dollars  in thousands)**                 | ** ** | **Loan  Balance** | ** ** | **Impaired  Loan  Balance** | ** ** | **Number of  Impaired  Loans** | ** ** | **Specific  Allowance  on Impaired  Loans** | ** ** |
|---------------------------------------------|------------|-------------------|------------|-----------------------------|------------|--------------------------------|------------|---------------------------------------------|------------|
|                                        |       |              |       |                        |       |                           |       |                                        |       |
| Commercial loans                            |       | $                 | 324,126    |                        | $          | 14,632                         |       | 47                                          |       | $ | 1,105 |   |
| Real estate — commercial               |       | 259,388           |       | 13,009                      |       | 11                             |       | 3,563                                       |       |
| Real estate — commercial construction  |       | 62,430            |       | 11,871                      |       | 11                             |       | 780                                         |       |
| Real estate — residential              |       | 92,029            |       | 1,750                       |       | 6                              |       | 347                                         |       |
| Real estate — residential construction |       | 28,059            |       | 1,449                       |       | 4                              |       | 523                                         |       |
| Consumer loans                              |       | 116,902           |       | 2,319                       |       | 35                             |       | 1,028                                       |       |
| Lease financing receivables                 |       | 1,335             |       | 152                         |       | 5                              |       | 152                                         |       |
|                                        |       |              |       |                        |       |                           |       |                                        |       |
| Totals                                      |       | $                 | 884,269    |                        | $          | 45,182                         |       | 119                                         |       | $ | 7,498 |   |

 

Unearned income included in the carrying amount of the loan balancesabove was $795 thousand at March 31, 2010. The amount of deposit account overdrafts classified as loans abovetotaled $843 thousand at March 31, 2010.

 

The non-accrual loan and lease balance was $27.9 million at March 31,2010. The approximate gross interest income that would have been recorded forthe three months ending March 31, 2010 if the $27.9 million in non-accrualloans had been current in accordance with their original terms was $330thousand. The actual amount of interest income included in net income as ofMarch 31, 2010 on these loans was $5 thousand resulting from interestearned prior to the loans being placed on non-accrual status.

 

December 31, 2009

 
| **(Dollars  in thousands)**                 | ** ** | **Loan  Balance** | ** ** | **Impaired  Loan  Balance** | ** ** | **Number of  Impaired  Loans** | ** ** | **Specific  Allowance  on Impaired  Loans** | ** ** |
|---------------------------------------------|------------|-------------------|------------|-----------------------------|------------|--------------------------------|------------|---------------------------------------------|------------|
|                                        |       |              |       |                        |       |                           |       |                                        |       |
| Commercial loans                            |       | $                 | 334,286    |                        | $          | 13,269                         |       | 35                                          |       | $ | 1,029 |   |
| Real estate — commercial               |       | 261,643           |       | 12,071                      |       | 11                             |       | 3,637                                       |       |
| Real estate — commercial construction  |       | 66,204            |       | 8,786                       |       | 8                              |       | 135                                         |       |
| Real estate — residential              |       | 88,024            |       | 2,601                       |       | 7                              |       | 644                                         |       |
| Real estate — residential construction |       | 29,387            |       | 2,137                       |       | 7                              |       | 874                                         |       |
| Consumer loans                              |       | 120,767           |       | 2,596                       |       | 42                             |       | 1,148                                       |       |
| Lease financing receivables                 |       | 1,578             |       | 167                         |       | 8                              |       | 55                                          |       |
|                                        |       |              |       |                        |       |                           |       |                                        |       |
| Totals                                      |       | $                 | 901,889    |                        | $          | 41,627                         |       | 118                                         |       | $ | 7,522 |   |

 

Unearned income included in the carrying amount of the loan balancesabove was $746 thousand at December 31, 2009. The amount of depositaccount overdrafts classified as loans above totaled $220 thousand at December 31,2009.

 

The non-accrual loan and lease balance was $27.6 million atDecember 31, 2009. The approximate gross interest income that would havebeen recorded for the twelve months ending December 31, 2009 if the $27.6 millionin non-accrual loans had been current in accordance with their original termswas $1.8 million. The actual amount of interest income included in netincome as of December 31, 2009 on these loans was $960 thousandresulting from interest earned prior to the loans being placed on non-accrualstatus.

 

The following chart presentschanges in the allowance for loan and lease losses for the three months ended March 31,2010 and 2009:

 
| ** **                              | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------|------------|------------------------|------------|
| ** **                              | ** ** | **March 31,**     | ** ** |
| **(Dollars  in thousands)**             | ** ** | **2010**               | ** ** | **2009** | ** ** |
| Balance at beginning of period          |       | $                      | 23,217     |   | $ | 10,335 |   |
| Provision charged to operating expenses |       | 266                    |       | 1,387 |   |
| Recoveries                              |       | 137                    |       | 145 |   |
| Loans charged-off                       |       | (1,226                 | )          | (442 | ) |
| Allowance adjustment — Other       |       | 70                     |       | (162 | ) |
| Balance at end of period                |       | $                      | 22,464     |   | $ | 11,263 |   |

 

**9.****           ****IncomeTaxes**

 

TheCorporation has not recorded an income tax benefit for its net operating lossfor the three month period ended March 31, 2010. At March 31, 2010,the valuation allowance against the Corporation’s deferred tax asset increasedto $8.7 million from $7.5 million at December 31. 2009. The valuationallowance is recorded against a portion of the Corporation’s deferred taxassets after concluding that it was more likely than not that a portion of thedeferred tax asset would not be realized. In evaluating the ability to recoverour deferred tax assets, Management considers all available positive andnegative evidence regarding the ultimate realizability of our deferred taxassets including past operating results and our forecast of future taxableincome. In addition, general uncertainty surrounding the future economic andbusiness conditions have increased the likelihood of volatility in our futureearnings. The Corporation has concluded and recorded a valuation allowanceagainst its deferred tax asset, except for amounts available for carrybackclaims.

 

**10.****    ****OtherReal Estate Owned**

 

Other real estate owned (“OREO”) represents property owned by the Bankfollowing default by the borrowers. OREO property acquired through foreclosureis initially transferred at fair value based on an appraised value lessestimated cost to dispose. Adjustments are subsequently made to mark theproperty below this amount if circumstances warrant.  Losses arising from foreclosure transactionsare charged against the allowance for loan and lease losses. Costs to maintainreal estate owned and any subsequent gains or losses are included in theCorporation’s results of operations. In June 2010, the Corporation soldeight OREO properties to one buyer. A charge of $1.3 million was recordedduring the first quarter 2010 to reduce the carrying amount of these assets toan amount that reflects the realizable value of these properties based on theactual sales price. The following table summarizes properties held as OREO asof March 31, 2010 and December 31, 2009:

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 
| **(Dollars in thousands)** | ** ** | **March 31,  2010** | ** ** | **Number  of  properties** | ** ** | **December 31,  2009** | ** ** | **Number  of  properties** | ** ** |
|----------------------------|------------|--------------------------|------------|----------------------------|------------|-----------------------------|------------|----------------------------|------------|
| Land                       |       | $                        | 506        |                       | 5          |                        | $          | 49                         |       | 1 |   |
| Residential  1-4 family    |       | 2,412                    |       | 12                         |       | 3,643                       |       | 15                         |       |
| Total                      |       | $                        | 2,918      |                       | 17         |                        | $          | 3,692                      |       | 16 |   |

 

**11.  Other Assets**

 

AtDecember 31, 2009, the Corporation had an $8.7 million receivable recordedin other assets which related to a former BOLI policy which the Bank hadsurrendered in 2008. In the first quarter 2010, the Corporation received cashproceeds in full payment of this receivable.

 

**12.****    ****Borrowings**

 

AtMarch 31, 2010, the Bank had borrowings totaling $130.3 million comparedto $172.9 million at December 31, 2009. During the first quarter 2010 borrowings from the FHLB decreased $42.6million to $101.8 million as compared to December 31, 2009. Scheduledmaturities during the first quarter of 2010 totaled $42.5 million.  The remaining decrease was due toamortization.

 

**13.****    ****Earnings (Loss) per Share**

 

**Three Months ended March 31,2010**

 
| ** **                                                                      | ** ** | **Income**      | ** ** | ** **        | ** ** | ** **    | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------|------------|-------------------|------------|---------------|------------|
| ** **                                                                      | ** ** | **(thousands)** | ** ** | **Shares (1)**    | ** ** | **Per Share** | ** ** |
| ** **                                                                      | ** ** | **(numerator)** | ** ** | **(denominator)** | ** ** | **Amount**    | ** ** |
| Basic loss from continuing operations per share                                 |       |            |       |              |       |          |       |
| Net loss from continuing operations                                             |       | $               | (604       | )                 | 6,336,434  |          | $          | (0.10 | ) |
| Effect of dilutive securities                                                   |       |            |       |              |       |          |       |
| Options to purchase common stock                                                |       | —          |       | —            |       | —        |       |
| Diluted net loss from continuing operations  available to common stockholders   |       | $               | (604       | )                 | 6,336,434  |          | $          | (0.10 | ) |
|                                                                            |       |            |       |              |       |          |       |
| Basic loss from discontinued operations per share                               |       |            |       |              |       |          |       |
| Net loss from discontinued operations                                           |       | (1,197          | )          | 6,336,434         |       | (0.19         | )          |
| Effect of dilutive securities                                                   |       |            |       |              |       |          |       |
| Options to purchase common stock                                                |       | —          |       | —            |       | —        |       |
| Diluted net loss from discontinued operations  available to common stockholders |       | $               | (1,197     | )                 | 6,336,434  |          | $          | (0.19 | ) |
|                                                                            |       |            |       |              |       |          |       |
| Basic loss available to common stockholders per  share                          |       |            |       |              |       |          |       |
| Net loss available to common stockholders                                       |       | (1,801          | )          | 6,336,434         |       | (0.28         | )          |
| Effect of dilutive securities                                                   |       |            |       |              |       |          |       |
| Options to purchase common stock                                                |       | —          |       | —            |       | —        |       |
| Diluted net loss available to common stockholders                               |       | $               | (1,801     | )                 | 6,336,434  |          | $          | (0.28 | ) |

 

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(1)          230,900 anti-dilutiveweighted average shares have been excluded from this computation because theoption exercise price was greater than the average market price of the commonshares.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**Three Months ended March 31, 2009**

 
| ** **                                                                        | ** ** | **Income**      | ** ** | ** **        | ** ** | ** **    | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------|------------|-------------------|------------|---------------|------------|
| ** **                                                                        | ** ** | **(thousands)** | ** ** | **Shares (1)**    | ** ** | **Per Share** | ** ** |
| ** **                                                                        | ** ** | **(numerator)** | ** ** | **(denominator)** | ** ** | **Amount**    | ** ** |
| Basic income from continuing operations per share                                 |       |            |       |              |       |          |       |
| Net income from continuing operations                                             |       | $               | 139        |              | 6,242,252  |          | 0.02       |   |
| Effect of dilutive securities                                                     |       |            |       |              |       |          |       |
| Options to purchase common stock                                                  |       | —          |       | —            |       | —        |       |
| Diluted net income from continuing operations  available to common stockholders   |       | $               | 139        |              | 6,242,252  |          | 0.02       |   |
|                                                                              |       |            |       |              |       |          |       |
| Basic income from discontinued operations per  share                              |       |            |       |              |       |          |       |
| Net income from discontinued operations                                           |       | 3,181           |       | 6,242,252         |       | 0.51          |       |
| Effect of dilutive securities                                                     |       |            |       |              |       |          |       |
| Options to purchase common stock                                                  |       | —          |       | —            |       | —        |       |
| Diluted net income from discontinued operations  available to common stockholders |       | $               | 3,181      |              | 6,242,252  |          | 0.51       |   |
|                                                                              |       |            |       |              |       |          |       |
| Basic income available to common stockholders per  share                          |       |            |       |              |       |          |       |
| Net income available to common stockholders                                       |       | 3,320           |       | 6,242,252         |       | 0.53          |       |
| Effect of dilutive securities                                                     |       |            |       |              |       |          |       |
| Options to purchase common stock                                                  |       | —          |       | —            |       | —        |       |
| Diluted net income available to common  stockholders                              |       | $               | 3,320      |              | 6,242,252  |          | $          | 0.53 |   |
|                                                                                   |            |                 |            |                   |            |               |            |  |  |

 

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(1)          297,154 anti-dilutiveweighted average shares have been excluded from this computation because theoption exercise price was greater than the average market price of the commonshares.

 

**14.**** ****Comprehensive Income (Loss)**

 

Components of comprehensive income (loss) are presented in thefollowing chart:

 
| ** **                                                        | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                        | ** ** | **March 31,**     | ** ** |
| ** **                                                        | ** ** | **2010**               | ** ** | **2009** | ** ** |
| Unrealized gains (losses) on securities:                          |       |                   |       |   |   |
| Unrealized gains (losses) arising in period                       |       | $                      | 801        |   | $ | (523 | ) |
| Reclassification adjustment                                       |       | —                 |       | (88 | ) |
| Net unrealized gain (loss)                                        |       | 801                    |       | (611 | ) |
| Other comprehensive income (loss) before taxes                    |       | 801                    |       | (611 | ) |
| Income tax (expense) benefit                                      |       | (273                   | )          | 207 |   |
| Other comprehensive income (loss)                                 |       | 528                    |       | (404 | ) |
| Net (loss) income including non-controlling  interests            |       | (1,603                 | )          | 3,488 |   |
| Comprehensive (loss) income                                       |       | (1,075                 | )          | 3,084 |   |
| Comprehensive income attributable to non-  controlling interests  |       | (198                   | )          | (168 | ) |
| Comprehensive (loss) income for First Chester  County Corporation |       | $                      | (1,273     | ) | $ | 2,916 |   |

 

**15.****      ****Fair Value Measurement and FairValue of Financial Instruments**

 

ASC820-10 defines fair value as the exchange price that would be received for anasset or paid to transfer a liability (an exit price) in an orderly transactionbetween market participants on the measurement date. ASC 820-10 alsoestablishes a fair value hierarchy which requires an entity to maximize the useof observable inputs and minimize the use of unobservable inputs when measuringfair value. ASC 820-10 clarifies proper fair value determination in a marketthat is not active and provides an example to illustrate key considerations indetermining the fair value of a financial asset when the market for thatfinancial asset is not active. The Corporation considered the requirements ofASC 820-10 when estimating fair value.

 

ASC825-10 — Financial Instruments permits entities to choose to measure manyfinancial instruments and certain other items at fair value at specifiedelection dates. The Corporation elected to account for loans held for saleunder this election option.

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

ASC820-10 describes three levels of inputs that may be used to measure fair value:

 

·                  Level 1: Quoted prices (unadjusted) foridentical assets or liabilities in active markets that the entity has theability to access as of the measurement date.

 

·                  Level 2: Significant other observable inputsother than Level 1 prices, such as quoted prices for similar assets orliabilities, quoted prices in markets that are not active, and other inputsthat are observable or can be corroborated by observable market data.

 

·                  Level 3: Significant unobservable inputs thatreflect a company’s own assumptions about the assumptions that marketparticipants would use in pricing an asset or liability.

 

*Assets and Liabilities Measuredat Fair Value on a Recurring Basis*

 

Adescription of the valuation methodologies used for financial instrumentsmeasured at fair value on a recurring basis, as well as the classification ofthe instruments pursuant to the valuation hierarchy, are as follows:

 

Securities: Investmentsecurities available-for-sale are recorded at fair value on a recurring basis.Fair value measurement is based upon quoted prices, if available. If quotedprices are not available, fair values are measured using matrix pricing, whichis a mathematical technique used widely in the industry to value debtsecurities without relying exclusively on quoted prices for the specificsecurities but rather by relying on the securities’ relationship to otherbenchmark quoted securities.

 

Level1 Valuation Techniques and Inputs for Investment Securities

 

TheCorporation reports U.S. Treasury and certain Bank equity securities at fairvalue utilizing Level 1 inputs. These securities are priced using observablequotations for the indicated security.

 

Level2 Valuation Techniques and Inputs for Investment Securities

 

Themajority of the Corporation’s investment securities are reported at fair valueutilizing Level 2 inputs. The valuations for U.S. Government agency, U.S.Government agency mortgage backed securities, residential and commercial CMO’s,and Corporation equity securities are obtained through independent, third-partypricing services. Prices obtained through these sources include market derivedquotations and matrix pricing and may include both observable and unobservableinputs. Fair market values take into consideration data such as dealer quotes,new issue pricing, trade prices for similar issues, prepayment estimates, cashflows, market credit spreads and other factors.

 

Thevaluations for state and municipal obligations are obtained throughindependent, third-party pricing services as well.  Valuations for these securities are performedusing information on identical or similar securities provided by market makers,broker/dealers and buy-side firms, new issue sales and bid-wanted lists. Theindividual securities are then priced based on mapping the characteristics ofthe security such as obligation type (General Obligation, Revenue, etc.),maturity, state discount and premiums, call features, taxability and otherconsiderations.

 

Level3 Valuation Techniques and Inputs for Investment Securities

 

Otherequity securities are primarily comprised of Federal Home Loan Corporation (“FHLB”)and Federal Reserve Board (“FRB”) stock. The Corporation is required to purchase and hold stock in the FHLB andFRB to satisfy membership and borrowing requirements. This stock is restrictedin that it can only be sold

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

tothe FHLB, FRB or to another member institution, and all sales must be at par.As a result of these restrictions, these equity securities are unlike otherinvestment securities insofar as there is no trading market and the transferprice is determined by membership rules and not by marketparticipants.  Accordingly, theCorporation’s valuation for these securities is estimated at its par value.

 

MortgageServicing Rights (“MSRs”): To determine the fair value of MSRs, theBank uses an independent third party to estimate the present value of estimatedfuture net servicing income. This valuation method incorporates an assumptionthat market participants would use in estimating future net servicing income,which include estimates of the cost to service, the discount rate, custodialearnings rate, an inflation rate, ancillary income, prepayment speeds, anddefault rates and losses. The fair value of servicing rights was determinedusing discount rates ranging from 8.0% to 10.4%, prepayment speeds ranging from6.1% to 42.9% depending on the stratification of the specific right, and aweighted average default rate of 0.5%. The Corporation records the MSR as arecurring Level 3.

 

TheCorporation had no transfers in or out of Level 1 and Level 2 during the periodended March 31, 2010.

 

Thetable below presents the balance of assets and liabilities from continuingoperations at March 31, 2010 and December 31, 2009, measured at fairvalue on a recurring basis:

 
| **(Dollars  in thousands)**                       | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|------------|------------|
| **March 31,  2010**                          | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total**  | ** ** |
|                                              |       |        |       |        |       |        |       |       |       |
| Assets                                            |       |        |       |        |       |        |       |       |       |
| Investment securities available for sale:         |       |        |       |        |       |        |       |       |       |
| U.S. Treasury                                     |       | $           | 5,020      |        | $          | —      |       | $          | —     |   | $ | 5,020 |   |
| U.S. Government agency                            |       | —      |       | 2,028       |       | —      |       | 2,028      |       |
| U.S. Government agency mortgage-backed securities |       | —      |       | 34,145      |       | —      |       | 34,145     |       |
| CMO — Residential                            |       | —      |       | 959         |       | —      |       | 959        |       |
| CMO — Commercial                             |       | —      |       | 825         |       | —      |       | 825        |       |
| State and municipal                               |       | —      |       | 3,865       |       | —      |       | 3,865      |       |
| Corporate securities                              |       | —      |       | 6,359       |       | —      |       | 6,359      |       |
| Bank equity securities                            |       | 3           |       | 569         |       | —      |       | 572        |       |
| Other equity securities                           |       | —      |       | —      |       | 11,523      |       | 11,523     |       |
| Mortgage servicing rights                         |       | —      |       | —      |       | 623         |       | 623        |       |
|                                                   |            |             |            |             |            |             |            |            |            |  |  |  |  |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 
| **December 31,  2009**                       | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total** | ** ** |
|---------------------------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|-----------|------------|
|                                              |       |        |       |        |       |        |       |      |       |
| Assets                                            |       |        |       |        |       |        |       |      |       |
| Investment securities available for sale:         |       |        |       |        |       |        |       |      |       |
| U.S. Treasury                                     |       | $           | 20,016     |        | $          | —      |       | $         | —     |   | $ | 20,016 |   |
| U.S. Government agency                            |       | —      |       | 2,047       |       | —      |       | 2,047     |       |
| U.S. Government agency mortgage-backed securities |       | —      |       | 36,995      |       | —      |       | 36,995    |       |
| CMO — Residential                            |       | —      |       | 998         |       | —      |       | 998       |       |
| CMO — Commercial                             |       | —      |       | 808         |       | —      |       | 808       |       |
| State and municipal                               |       | —      |       | 4,594       |       | —      |       | 4,594     |       |
| Corporate securities                              |       | —      |       | 5,865       |       | —      |       | 5,865     |       |
| Bank equity securities                            |       | 3           |       | 530         |       | —      |       | 533       |       |
| Other equity securities                           |       | —      |       | —      |       | 10,842      |       | 10,842    |       |
| Mortgage servicing rights                         |       | —      |       | —      |       | 575         |       | 575       |       |
|                                                   |            |             |            |             |            |             |            |           |            |  |  |  |  |

 

*Assets Measured at FairValue on a Nonrecurring Basis*

 

Adescription of the valuation methodologies and classification levels used forfinancial instruments measured at fair value on a nonrecurring basis are listedas follows. These listed instruments are subject to fair value adjustments(impairment) as they are valued at the lower of cost or market.

 

Loans and leases:  The Corporation does not record loans at fairvalue on a recurring basis. However, from time to time, a loan is consideredimpaired and an allowance for loan losses is established. Loans for which it isprobable that payment of interest and principal will not be made in accordancewith the contractual terms of the loan agreement are considered impaired. Oncea loan is identified as individually impaired, Management measures impairmentin accordance with ASC 310. The fair value of impaired loans is estimated usingone of several methods, including collateral value, market value of similardebt, enterprise value, liquidation value and discounted cash flows. Thoseimpaired loans not requiring an allowance represent loans for which the fairvalue of the expected repayments or collateral exceed the recorded investmentsin such loans. At March 31, 2010 and December 31, 2009, substantiallyall of the impaired loans were evaluated based on the fair value of thecollateral less costs to sell. In accordance with ASC 820-10 impaired loanswhere an allowance is established based on the fair value of collateral requireclassification in the fair value hierarchy. When the fair value of thecollateral is based on an observable market price or a current appraised value,the Corporation records the impaired loan as nonrecurring Level 3.  The Bank’s policies require loan officers toregularly review accounts. Consistent with OCC guidance appraisals are updatedas warranted based on specific facts and circumstances. Appraisals are alsoupdated whenever a loan becomes criticized or classified.

 

OREO:  OREO is adjusted to fair value upon transferof the loans to foreclosed assets. Fair value is based upon independent marketprices, appraised values of the collateral or Management’s estimation of thevalue of the collateral. The Corporation records the foreclosed asset asnonrecurring Level 3.

 

Thetable below presents the balance of assets and liabilities from continuingoperations at March 31, 2010 and December 31, 2009, measured at fairvalue on a nonrecurring basis:

 
| **(Dollars  in thousands)**      | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** |
|----------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|------------|------------|
| **March 31,  2010**         | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total**  | ** ** |
|                             |       |        |       |        |       |        |       |       |       |
| Impaired loans & leases |       | $           | —     |        | $          | —      |       | $          | 37,684     |   | $ | 37,684 |   |
|                             |       |        |       |        |       |        |       |       |       |   |   |   |   |
| OREO                             |       | $           | —     |        | $          | —      |       | $          | 2,918      |   | $ | 2,918 |   |

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 
| **(Dollars  in thousands)**      | ** ** | ** **  | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** |
|----------------------------------|------------|-------------|------------|-------------|------------|-------------|------------|------------|------------|
| **December 31,  2009**      | ** ** | **Level 1** | ** ** | **Level 2** | ** ** | **Level 3** | ** ** | **Total**  | ** ** |
|                             |       |        |       |        |       |        |       |       |       |
| Impaired loans & leases |       | $           | —     |        | $          | —      |       | $          | 34,105     |   | $ | 34,105 |   |
| OREO                             |       |        | —     |        |       | —      |       |       | 3,692      |   |   | 3,692 |   |

 

*Disclosures about financialinstruments*

 

Thetable below presents the rollforward of assets from continuing operations thatare valued using significant unobservable inputs (Level 3) for the three monthsended March 31, 2010:

 
| ** **                                | ** ** | **Mortgage  Servicing Rights** | ** ** | **Investments** | ** ** |
|-------------------------------------------|------------|--------------------------------|------------|-----------------|------------|
| Beginning balance                         |       | $                              | 575        |            | $          | 10,842 |   |
| Total gains (losses) realized/unrealized: |       |                           |       |            |       |
| Included in earnings                      |       | 48                             |       | —          |       |
| Included in other comprehensive loss      |       | —                         |       | (32             | )          |
| Purchases                                 |       | —                         |       | 713             |       |
| Maturities                                |       | —                         |       | —          |       |
| Prepayments                               |       | —                         |       | —          |       |
| Calls                                     |       | —                         |       | —          |       |
| Transfers into Level 3                    |       | —                         |       | —          |       |
| Ending Balance                            |       | $                              | 623        |            | $          | 11,523 |   |

 

The estimated fair values and carrying amounts of the assets andliabilities from continuing operations are summarized as follows:

 
| ** **                                                      | ** ** | **March 31, 2010** | ** ** | **December 31, 2009** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                      | ** ** | **Estimated**           | ** ** | **Carrying**               | ** ** | **Estimated** | ** ** | **Carrying** | ** ** |
| **(Dollars  in thousands)**                                     | ** ** | **Fair Value**          | ** ** | **Amount**                 | ** ** | **Fair Value** | ** ** | **Amount** | ** ** |
| Financial Assets                                                |       |                    |       |                       |       |   |   |   |   |
| Cash and cash equivalents                                       |       | $                       | 207,462    |                       | $          | 207,462 |   | $ | 146,681 |   | $ | 146,681 |   |
| Investment securities available-for-sale                        |       | 65,296                  |       | 65,296                     |       | 82,698 |   | 82,698 |   |
| Gross loans and leases                                          |       | 850,243                 |       | 884,269                    |       | 866,754 |   | 901,889 |   |
| Mortgage servicing rights                                       |       | 623                     |       | 623                        |       | 575 |   | 575 |   |
|                                                            |       |                    |       |                       |       |   |   |   |   |
| Financial Liabilities                                           |       |                    |       |                       |       |   |   |   |   |
| Deposits with no stated maturities                              |       | 580,198                 |       | 580,198                    |       | 594,278 |   | 594,278 |   |
| Deposits with stated maturities                                 |       | 496,153                 |       | 492,642                    |       | 518,642 |   | 516,022 |   |
| FHLB and other borrowings                                       |       | 132,917                 |       | 130,254                    |       | 175,904 |   | 172,897 |   |
| Subordinated debentures                                         |       | 14,574                  |       | 20,795                     |       | 12,410 |   | 20,795 |   |
|                                                            |       |                    |       |                       |       |   |   |   |   |
| Off-Balance-Sheet                                               |       |                    |       |                       |       |   |   |   |   |
| Commitments to extend credit and outstanding  letters of credit |       | 159,156                 |       | 159,156                    |       | 205,468 |   | 205,468 |   |
|                                                                 |            |                         |            |                            |            |  |  |  |  |  |  |  |  |

 

**16.****      ****Accounting for Stock-BasedCompensation Plans**

 

At March 31, 2010, the Corporation had one stock basedcompensation plan, pursuant to which, shares of the Corporation’s common stockcould be issued, subject to certain restrictions. The plan, adopted in 2005,allows the Corporation to grant up to 150,000 shares of restricted stock toemployees. During the three months ended March 31, 2010, the Corporationgranted no shares of restricted stock under this plan. These restricted stock 

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

grants are subject to accelerated vesting of all or a portion of theshares upon the occurrence of certain events. A summary of the Corporation’s unvested restricted shares is as follows:

 

(Dollarsin thousands, except shares, and per share data)

 
| ** **                       | ** ** | **Shares** | ** ** | **Grant Date Fair  Value** | ** ** | **Aggregate Intrinsic  Value  of Unvested Shares** | ** ** |
|----------------------------------|------------|------------|------------|----------------------------|------------|----------------------------------------------------|------------|
| Unvested at January 1, 2010 |       | 54,474     |       | $                          | 10.57      |                                               | $          | 503 |   |
| Granted                          |       | —     |       | $                          |       |                                               |       |   |
| Vested                           |       | (2,199     | )          | $                          | 21.05      |                                               |       |   |
| Forfeited                        |       | (1,400     | )          | $                          | 11.35      |                                               |       |   |
| Unvested at March 31, 2010  |       | 50,875     |       | $                          | 10.09      |                                               | $          | 518 |   |

 

The Corporation recorded approximately $36 thousand and $41 thousand ofrestricted stock expense for the three months ended March 31, 2010 and2009, respectively.

 

The Corporation’s ability to issue stock options under the Corporation’s1995 Stock Option Plan has expired. However, outstanding stock options remainin effect according to their terms. Aggregated information regarding theCorporation’s 1995 Stock Option Plan and the options assumed in the AHBacquisition as of March 31, 2010 is presented below.

 

(Dollars in thousands,except shares, per share and years data)

 
| **Options**                         | ** ** | **Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-Average  Remaining  Contractual  Term (years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|-------------------------------------|------------|------------|------------|-----------------------------------------|------------|------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at January 1, 2010 |       | 230,900    |       | $                                       | 15.79      |                                                       | 3.32       |                            | $          | — |   |
| Granted                             |       | —     |       |                                    |       |                                                       |       |                            |       |
| Exercised                           |       | —     |       |                                    |       |                                                       |       |                            |       |
| Forfeited                           |       | —     |       |                                    |       |                                                       |       |                            |       |
| Expired                             |       | —     |       | $                                       | —     |                                                       |       |                            |       |   |
| Outstanding at March 31, 2010  |       | 230,900    |       | $                                       | 15.75      |                                                       | 3.07       |                            | $          | — |   |
| Exercisable at March 31, 2010  |       | 230,900    |       | $                                       | 15.75      |                                                       | 3.07       |                            | $          | — |   |

 

There were no options granted during the three months ended March 31,2010.  There was no intrinsic value(market value on date of exercise less grant price) of options at March 31,2010 as all options had an exercise price that was higher than the market priceon March 31, 2010.

 

**17.****      ****Commitmentand Contingencies**

 

**Reserve for Unfunded Commitments**

 

TheCorporation maintains a reserve for unfunded loan commitments and letters ofcredit which is reported in other liabilities in the Unaudited ConsolidatedStatements of Financial Condition consistent with ASC 825-10. As of the balancesheet date, the Corporation records estimated losses inherent with unfundedloan commitments in accordance with ASC 450-20, and estimated futureobligations under letters of credit in accordance with ASC 460-10. Themethodology used to determine the adequacy of this reserve is integrated in theCorporation’s process for establishing the allowance for loan losses andconsiders the probability of future losses and obligations that may be incurredunder these off-balance sheet agreements.  The reserve for unfundedloan commitments and letters of credit as of March 31, 2010 andDecember 31, 2009 was approximately $599 thousand and $669 thousand,respectively. Management believes this reserve level is sufficient to absorbestimated probable losses related to these commitments.

 

**Loan Recourse**

 

TheCorporation sells its residential mortgage loans on a non-recourse basis. TheCorporation also provides representations and warranties to purchasers andinsurers of the loans sold. In the event of a breach of these 

 

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**FIRST CHESTER COUNTY CORPORATIONAND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(UNAUDITED)**

 

representationsand warranties, the Corporation may be required to repurchase a mortgage loanor indemnify the purchaser, and any subsequent loss on the mortgage loan may beborne by the Corporation. If there is no breach of a representation andwarranty provision, the Corporation has no obligation to repurchase the loan orindemnify the investor against loss. The unpaid principal balance of the loanssold by the Corporation represents the maximum potential exposure related torepresentations and warranty provisions; however, the Corporation cannotestimate its maximum exposure because it does not service all of the loans forwhich it has provided a representation or warranty. As of March 31, 2010and December 31, 2009, the Corporation had a liability of $733 thousandand $688 thousand, respectively, included in Liabilities related to assets heldfor sale on the Consolidated Balance Sheet, for probable losses related to theCorporation’s recourse exposure.  Thisliability is part of our discontinued mortgage banking operations, however itis anticipated that the Corporation may retain all or a portion of thisliability after the anticipated sale of the mortgage banking division.

 

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**ITEM 2.          MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Thisdiscussion is intended to further your understanding of the consolidatedfinancial condition and results of operations of First Chester CountyCorporation and its direct and indirect subsidiaries. It should be read inconjunction with the consolidated financial statements included in this report.

 

**OVERVIEW**

 

TheCorporation reported net loss from continuing operations of $604 thousand forthe quarter ended March 31, 2010, as compared to net income fromcontinuing operations of $139 thousand for the quarter ended March 31,2009.

 

Thefollowing is an overview of key factors affecting our March 31, 2010results from continuing operations:

 

·                  Salaries and employee benefits decreased $1.7million to $3.6 million for the three months ending March 31, 2010, ascompared to the same period in 2009.

 

·                  The provision for loan and lease lossesdecreased $1.1 million to $266 thousand during the three months ended March 31,2010.

 

·                  Net interest income from continuingoperations decreased $686 thousand to $8.3 million for the three-month periodended March 31, 2010, as compared to the same period in 2009.

 

·                  Professional fees increased $1.2 million to $1.8million for the three months ending March 31, 2010.

 

·                  Write-down of OREO was $1.3 million for thethree months ending March 31, 2010. There were no such write-downs fromcontinuing operations in the same period in 2009.

 

Duringfirst quarter 2010, we announced the potential sale of the AHB mortgage bankingsegment.  Accordingly, assets related tomortgage banking operations have been reclassified to discontinued assets heldfor sale and the mortgage banking operations related to this segment have been reclassified,and are now reflected as discontinued operations.  Refer to Note 6 of theaccompanying consolidated financial statements for information related todiscontinued operations.

 

**CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES**

 

Ouraccounting and reporting policies conform with GAAP and the general practiceswithin the financial services industry. The preparation of financial statementsin conformity with GAAP requires Management to make estimates and assumptionsthat affect the amounts reported in the financial statements and theaccompanying notes. Actual results could differ from those estimates.

 

Criticalaccounting estimates are necessary in the application of certain accountingpolicies and procedures, and are particularly susceptible to significantchange. Critical accounting policies are defined as those that are reflectiveof significant judgments and uncertainties, and could potentially result inmaterially different results under different assumptions and conditions. Inaddition to the information contained in Note 4 of the accompanyingconsolidated financial statements and Note C of the consolidated financialstatements included in our 2009 Annual Report, management believes that themost critical accounting policies, which involve the most complex or subjectivedecisions or assessments, are as follows:

 

**Discontinued Operations**

 

Inaccordance with ASC 360-10-45,**“Property, Plant and Equipment — Overall —Other Presentation Matters,” we classify the assets and liabilities of abusiness as held-for-sale when management approves and commits to a formal planof sale and it is probable that the sale will be completed. The carrying valueof the net assets of the business held-for-sale are then recorded at the lowerof their carrying value or fair market value, less costs to sell, and we ceaseto record depreciation and amortization expense associated with assetsheld-for-sale.

 

Inaccordance with ASC 205-20-45, “Presentation of Financial Statements —Discontinued Operations — Other Presentation Matters,”  the results of operations of a component ofan entity that has either been disposed of, or is classified as held for sale,shall be reported in discontinued operations if both the operations and cashflows of the component have been, or will be, eliminated from ongoingoperations of the entity as a result of the disposal transaction and the entitywill not have any significant continuing involvement in the operations of thecomponent after the disposal transaction.

 

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**OTHERASSETS**

 

Otherassets decreased $10.3 million to $22.3 million at March 31, 2010, ascompared to $32.6 million at December 31, 2009. At December 31, 2009,the Corporation had an $8.7 million receivable recorded in other assets whichrelated to a former BOLI policy which the Bank had surrendered in 2008. In thefirst quarter 2010, the Corporation received cash proceeds in full payment ofthis receivable.

 

**NETINTEREST INCOME**

 

Netinterest income is the difference between interest income earned oninterest-earning assets and interest expense paid on interest-bearingliabilities. The following table provides detail regarding the Corporation’saverage balances with corresponding interest income (on a tax-equivalent basis)and interest expense from both continuing and discontinued operations, as wellas yield and cost information for the periods presented.  Management’s discussion and analysis of netinterest income, interest income, and interest expense is based on aggregatedamounts of continuing and discontinued operations.

 
| ** **                                                                              | ** ** | **Three Months ended March 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                              | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| ** **                                                                              | ** ** | **Average**                           | ** ** | ** ** | ** ** | ** ** | ** ** | **Average** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **(Dollars  in thousands)**                                                             | ** ** | **Balance**                           | ** ** | **Interest** | ** ** | **Rate%** | ** ** | **Balance** | ** ** | **Interest** | ** ** | **Rate%** | ** ** |
| ASSETS                                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Federal funds sold, interest-bearing deposits in banks  and other overnight investments |       | $                                     | 182,635    |   | $ | 121 |   | 0.27 | % | $ | 26,516 |   | $ | 28 |   | 0.43 | % |
| Investment securities:                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                 |       | 64,278                                |       | 395 |   | 2.49 | % | 101,900 |   | 1,152 |   | 4.58 | % |
| Tax-exempt (1)                                                                          |       | 4,077                                 |       | 51 |   | 5.07 | % | 9,606 |   | 114 |   | 4.81 | % |
| Total investment securities                                                             |       | 68,355                                |       | 446 |   | 2.65 | % | 111,506 |   | 1,266 |   | 4.60 | % |
|                                                                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Loans held for sale                                                                     |       | 115,959                               |       | 1,194 |   | 4.18 | % | 151,157 |   | 1,844 |   | 4.95 | % |
|                                                                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Loans and leases: (2)                                                                   |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Taxable                                                                                 |       | 873,621                               |       | 12,220 |   | 5.67 | % | 919,111 |   | 12,950 |   | 5.71 | % |
| Tax-exempt (1)                                                                          |       | 14,826                                |       | 223 |   | 6.09 | % | 20,737 |   | 375 |   | 7.34 | % |
| Total loans and leases                                                                  |       | 888,447                               |       | 12,443 |   | 5.68 | % | 939,848 |   | 13,325 |   | 5.75 | % |
|                                                                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                                                           |       | 1,255,396                             |       | 14,204 |   | 4.59 | % | 1,229,027 |   | 16,463 |   | 5.43 | % |
|                                                                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest-earning assets                                                             |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses                                                     |       | (24,012                               | )          |   |   |   |   | (10,569 | ) |   |   |   |   |
| Cash and due from banks                                                                 |       | 20,391                                |       |   |   |   |   | 27,952 |   |   |   |   |   |
| Other assets                                                                            |       | 58,474                                |       |   |   |   |   | 61,187 |   |   |   |   |   |
| Total assets                                                                            |       | 1,310,249                             |       |   |   |   |   | $ | 1,307,597 |   |   |   |   |   |
|                                                                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| LIABILITIES AND EQUITY                                                                  |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Savings, NOW, and money market deposits                                                 |       | $                                     | 430,673    |   | 725 |   | 0.68 | % | $ | 424,994 |   | $ | 1,205 |   | 1.15 | % |
| Certificates of deposit and other time                                                  |       | 491,643                               |       | 2,535 |   | 2.09 | % | 447,521 |   | 3,266 |   | 2.96 | % |
| Total interest-bearing deposits                                                         |       | 922,316                               |       | 3,260 |   | 1.43 | % | 872,515 |   | 4,471 |   | 2.08 | % |
| Subordinated debt                                                                       |       | 20,795                                |       | 271 |   | 5.29 | % | 15,465 |   | 174 |   | 4.56 | % |
| Federal Home Loan Bank advances and other borrowings                                    |       | 145,175                               |       | 1,465 |   | 4.09 | % | 174,200 |   | 1,536 |   | 3.58 | % |
| Total interest-bearing                                                                  |       | 1,088,286                             |       | 4,996 |   | 1.86 | % | 1,062,180 |   | 6,181 |   | 2.36 | % |
| Non-interest-bearing liabilities:                                                       |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Non-interest-bearing demand deposits                                                    |       | 150,729                               |       |   |   |   |   | 144,060 |   |   |   |   |   |
| Other liabilities                                                                       |       | 15,009                                |       |   |   |   |   | 14,393 |   |   |   |   |   |
| Total liabilities                                                                       |       | 1,254,024                             |       |   |   |   |   | 1,220,633 |   |   |   |   |   |
| Equity                                                                                  |       | 56,225                                |       |   |   |   |   | 86,964 |   |   |   |   |   |
| Total liabilities and equity                                                            |       | $                                     | 1,310,249  |   |   |   |   |   | $ | 1,307,597 |   |   |   |   |   |
|                                                                                    |       |                                  |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income (tax equivalent) / margin on  earning assets                        |       |                                  |       | $ | 9,208 |   | 2.97 | % |   |   | $ | 10,282 |   | 3.39 | % |
| Less net interest income from discontinued  operations (3)                              |       |                                  |       | 846 |   |   |   |   |   | 1,165 |   |   |   |
| Less tax equivalent adjustment                                                          |       |                                  |       | 87 |   |   |   |   |   | 156 |   |   |   |
| Net interest income from continuing operations                                          |       |                                  |       | $ | 8,275 |   |   |   |   |   | $ | 8,961 |   |   |   |

 

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(1)                     The indicated income andannual rate are presented on a taxable equivalent basis using the federalmarginal rate of 34% adjusted for the TEFRA 20% interest expense disallowancefor March 31, 2010 and 2009.

 

(2)                     Non-accruing loans areincluded in the average balance.

 

(3)                     Net interest income of themortgage banking segment includes income from loans held for sale and imputedinterest expense calculated using the Corporation’s internal matched fundstransfer pricing methodology.  See Note 6of the accompanying financial statements for further discussion of discontinuedoperations.

 

Netinterest income on a tax equivalent basis for the three-month period ending March 31,2010 was $9.2 million, a decrease of 10.7% compared to $10.3 million for thesame period in 2009. The net interest margin on earning assets decreased to2.97% for the three-month period ending March 31, 2010, a decline of 42basis points (one basis point is equal to 1/100 of a percent) versus the 3.39%recorded in the same period of 2009.

 

Theyield earned on average interest-earning assets, on a tax equivalent basis, was4.59% for the three-month period ending March 31, 2010, compared to 5.43%for the same period in 2009, a decline of 84 basis points. The average ratepaid on interest bearing liabilities from decreased 50 basis points to 1.86% inthree-month period ending March 31, 2010 from 2.36% in the same period in2009.

 

Averageinterest-earning assets increased $26.4 million, to $1.255 billion in thethree-month period ending March 31, 2010 compared to $1.229 billion in thesame period last year. Federal funds sold and other short term investmentsincreased $156.1 million, partly offset by a $43.2 million decrease ininvestment securities, a $51.4 million decrease in loans and leases and a $35.2million decrease in loans held for sale.

 

Averageinterest-bearing liabilities increased $26.1 million to $1.088 billion in thethree-month period ending March 31 2010 from $1.062 billion in the sameperiod last year. Certificates of deposit and other time deposits increased$44.1 million, other interest-bearing deposits increased $5.7 million andsubordinated debt increased $5.3 million. Average FHLB advances and otherborrowings declined $29.0 million.

 

**INTERESTINCOME**

 

Interestincome, on a tax equivalent basis, declined $2.3 million, or 13.7%, to $14.2million for the three-month period ending March 31, 2010, compared to$16.5 million for the same period in 2009.

 

Interestincome from investment securities declined $820 thousand to $446 thousand forthe three-month period ending March 31, 2010, compared to $1.3 million forthe same period last year.  The averagebalance of the investment portfolio decreased 38.7% to $68.4 million,reflecting management’s decision to invest available cash in more secure, butlower yielding, overnight investment alternatives, as such, the average yieldof the portfolio fell to 2.65% from 4.60%.

 

Loanand lease interest income declined $882 thousand to $12.4 million for thethree-month period ending March 31 2010, compared to $13.3 million for thesame period 2009, primarily as a result of the decrease in average loans of$51.4 million driven by the lack of organic loan growth and the sale of $52.5million of commercial and commercial real estate loans to Tower in December 2009.

 

Offsettingthese decreases, interest income from federal funds sold, interest-bearingdeposits in banks and other overnight investments for the three-month periodending March 31 2010, increased $93 thousand to $121 thousand from theprior year as their average balances increased $156.1 million offset by yielddecreases of 16 basis points to 0.27%. The increased average balance resultedfrom management’s decision to enhance Bank liquidity by utilizing lower risk,shorter term investment alternatives.

 

**INTERESTEXPENSE**

 

Interestexpense, on a tax equivalent basis, declined $1.2 million to $5.0 million forthe three-month period ending March 31, 2010, compared to $6.2 million forthe same period in 2009.

 

Interestexpense on interest bearing deposits fell $1.2 million to $3.3 million for thethree-month period ending March 31 2010 from the same period in 2009.  The decrease was driven by the decline in theaverage rate paid of 65 basis points to 1.43%, offset by a $49.8 millionincrease in average balances, largely from higher certificates of deposit.  The increase in certificates of depositbalances was primarily due to fourth quarter 2009 certificate of depositpromotion which was undertaken to increase liquidity and lengthen thematurities of liabilities supporting earning assets to help mitigate the riskof using interest rates.

 

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Interestexpense on FHLB advances and other borrowings declined $71 thousand to $1.5million for the three-month period ending March 31 2010, compared to thesame period 2009.  The average balance ofFHLB advances and other borrowings declined by $29.0 million primarilycomprised of a $49.2 million reduction in average FHLB advances at the Bankpartially offset by a $23.1 million increase in average borrowings at the parentcompany.   FHLB advances decreased due toincreases in deposit balances and a decrease in the funding needs of themortgage banking operations.  The aboveoffsetting increase at the parent company is due to borrowings from Tower whichoccurred in December 2009 and bear a rate of 6.0%.

 

Interestexpense paid on subordinated debt increased $97 thousand to $271 thousand forthe three-month period ending March 31, 2010 from $174 thousand in thesame period last year. This increase was largely driven by the issuance of $5.3million dollars of preferred securities in April of 2009 at a rate of12.00%.

 

**ASSETQUALITY AND ALLOWANCE FOR LOAN AND LEASE LOSSES**

 

*Allowancefor loan and lease losses*

 

Theallowance for loans and lease losses decreased $753 thousand to $22.5 millionat March 31, 2010, as compared to December 31, 2009.  The decrease in the allowance for loan lossesis primarily the result of a $17.6 million decrease in outstanding loans andleases balances and net charge-offs of $1.1 million during the first quarter2010.  The allowance for loan and leaselosses as a percentage of gross loans and leases at March 31, 2010 was2.54%, as compared to 2.57% at December 31, 2009.

 

Thepercentage of non-performing loans to gross loans was 5.11% at March 31,2010, compared to 4.67% at December 31, 2009, as total non-performingloans increased $3.0 million during the first quarter.   The allowance for loan and lease losses as apercentage of non-performing loans decreased to 49.72%, as compared to 55.07%at December 31, 2009.   The specificreserves related to non-performing assets remained relatively flat at $7.5million as compared to December 31, 2009. Several commercial real estate loans that migrated into an impaired loanclassification during the first quarter 2010 required nominal specific reservesbased on the collateral securing these impaired loans.

 

*Provisionfor loan and lease losses*

 

Duringthe three months ended March 31, 2010 and 2009, we recorded a $266 thousandprovision for loan and lease losses as compared to $1.4 million for the sameperiod in 2009.  This decrease wasprimarily result of loans that were changed-off in the first quarter that werespecifically reserved for at December 31, 2009, as well as a decline in loanbalances over the first quarter as noted above.

 

*Netcharge-offs*

 

Netcharge-offs in the first quarter 2010 were $1.1 million, compared to $297thousand of net charge-offs during the same period in 2009. The increasein charge-offs reflects the deterioration of economic conditions and resultingfailure of businesses, devaluation of collateral values and negative impact onconsumers’ ability to service debt.  A significant portion of loanscharged-off in the first quarter 2010 related to loans that had been evaluatedand deemed impaired at December 31, 2009. The specific reserves allocated to these impaired loans wereapproximately $663 thousand at December 31, 2009.

 

Thefollowing chart presents an analysis of the Allowance for Loan and LeaseLosses:

 
| ** **                                                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| **(Dollars in thousands)**                                                           | ** ** | **2010**                               | ** ** | **2009** | ** ** |
|                                                                                 |       |                                   |       |   |   |
| Balance at beginning of period                                                       |       | $                                      | 23,217     |   | $ | 10,335 |   |
|                                                                                 |       |                                   |       |   |   |
| Provision charged to operating expense                                               |       | 266                                    |       | 1,387 |   |
|                                                                                 |       |                                   |       |   |   |
| Recoveries of loans previously charged-off                                           |       | 137                                    |       | 145 |   |
| Loans charged-off                                                                    |       | (1,226                                 | )          | (442 | ) |
| Net loan charge-offs                                                                 |       | (1,089                                 | )          | (297 | ) |
|                                                                                 |       |                                   |       |   |   |
| Allowance other adjustment (1)                                                       |       | 70                                     |       | (162 | ) |
|                                                                                 |       |                                   |       |   |   |
| Balance at end of period                                                             |       | $                                      | 22,464     |   | $ | 11,263 |   |
|                                                                                 |       |                                   |       |   |   |
| Period-end loans and leases outstanding                                              |       | $                                      | 884,269    |   | $ | 940,131 |   |
| Average loans outstanding                                                            |       | $                                      | 888,447    |   | $ | 939,848 |   |
|                                                                                 |       |                                   |       |   |   |
| Allowance for loan and lease losses as a  percentage of period-end loans outstanding |       | 2.54                                   | %          | 1.20 | % |
| Net charge-offs to average loans outstanding                                         |       | 0.12                                   | %          | 0.03 | % |

 

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(1)          The “Allowance otheradjustment” represents the reclassification of an allowance for possible losseson unfunded loans and unused lines of credit. These loans and lines of credit, although unfunded, have been committedto by the Bank.

 

*Non-performing assets*

 

Non-performingassets include those loans on non-accrual status, loans past due 90 days ormore and still accruing, troubled debt restructurings and other loans deemedimpaired and other real estate owned.  Non-performing loans are generallycollateralized and are in the process of collection.  The percentage ofnon-performing loans to gross loans was 5.11% at March 31, 2010, comparedto 4.67% at December 31, 2009.  Thenon-accrual loan and lease balance at March 31, 2010 was $27.9 million,compared to $27.6 million at December 31, 2009.

 

*Non-accrualloan and leases*

 

Loans are generally placedon non-accrual when the loan becomes 90 days delinquent at which time allaccrued but unpaid interest is reversed. Interest income is no longer accrued on such assets and any futurepayments are applied as a reduction in the principal balance of the loan. Allnon-accrual loans are considered impaired assets and are evaluated individuallyfor required specific reserves.  Theapproximate gross interest income that would have been recorded for the threemonths ending March 31, 2010 if the $27.9 million in non-accrual loans hadbeen current in accordance with their original terms was approximately $330thousand. The actual amount of interest income included in net income as of March 31,2010 on these loans was $5 thousand relating to interest received prior toloans being placed on non accrual status.

 

*Restructuredand other impaired loans*

 

Through negotiations with aborrower, we may restructure a loan prior to the completion of its contractualterm. Modification of a loan’s terms constitutes a troubled debt restructuring(“TDR”) if we for economic or legal reasons related to the borrower’s financialdifficulties grant a concession that we would not otherwise consider. Not allmodifications of loan terms automatically result in a TDR. At March 31,2010, we had $17.3 million in restructured and other impaired loans of which$6.8 million are considered by management to be TDRs. At March 31, 2010,these TDRs continue to perform under their re-negotiated terms and remain onaccrual status. At March 31, 2010, $5.6 million in TDRs were attributableto various loans to one commercial real estate borrower.

 

The remaining $10.5 millionis comprised of loans which Management has reviewed individually and believesthe borrower’s financial performance and/or a shortfall in the value ofcollateral securing the loan provide enough evidence to deem the loan impaired.These other impaired loans were performing under their original contractualterms as of March 31, 2010.

 

*Potentialproblem loans*

 

As a recurring part of itsportfolio management program, we identified approximately $52.3 million inpotential problem loans at March 31, 2010. Potential problem loans areloans that are currently performing, but where the borrower’s operatingperformance or other relevant factors could result in potential creditproblems, and are typically classified by our loan rating system as “substandard.”At March 31, 2010, potential problem loans primarily consisted ofcommercial loans and commercial real estate. There can be no assurance thatadditional loans will not become nonperforming, require restructuring, orrequire increased provision for loan losses.

 

*Otherreal estate owned*

 

OREOrepresents property owned by us following default by the borrowers. OREOproperty acquired through foreclosure is initially transferred at fair valuebased on an appraised value less estimated 

 

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costto dispose. Adjustments are subsequently made to mark the property below thisamount if circumstances warrant.  Losses arising from foreclosuretransactions are charged against the allowance for loan losses. Costs tomaintain real estate owned and any subsequent gains or losses are included inour consolidated statements of income. The total OREO balance at March 31,2010 was $2.9 million, as compared to $3.7 million at December 31, 2009,and was comprised primarily of 1-4 family residential properties.

 

Thefollowing chart presents detailed information regarding non-performing assets:

 
| ** **                                                                                   | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(Dollars  in thousands)**                                                                  | ** ** | **2010**           | ** ** | **2009**              | ** ** |
|                                                                                         |       |               |       |                  |       |
| Past due over 90 days and still accruing                                                     |       | $                  | —     |                  | $          | 530 |   |
| Non-accrual loans and leases (1)                                                             |       | 27,854             |       | 27,581                |       |
| Restructured and other impaired loans                                                        |       | 17,328             |       | 14,046                |       |
| Total non-performing loans and leases                                                        |       | 45,182             |       | 42,157                |       |
|                                                                                         |       |               |       |                  |       |
| Other real estate owned                                                                      |       | 2,918              |       | 3,692                 |       |
| Total non-performing assets                                                                  |       | $                  | 48,100     |                  | $          | 45,849 |   |
|                                                                                         |       |               |       |                  |       |
| Non-performing loans and leases as a percentage of  total loans and leases                   |       | 5.11               | %          | 4.67                  | %          |
|                                                                                         |       |               |       |                  |       |
| Allowance for loan and lease losses as a percentage  of non-performing loans and leases |       | 49.72              | %          | 55.07                 | %          |
|                                                                                         |       |               |       |                  |       |
| Non-performing assets as a percentage of total  loans and other real estate owned       |       | 5.42               | %          | 5.06                  | %          |
|                                                                                         |       |               |       |                  |       |
| Allowance for loan and lease losses as a  percentage of non-performing assets           |       | 46.70              | %          | 50.64                 | %          |

 

----

(1)        Generally, the Bank places aloan or lease in non-accrual status when principal or interest has been indefault for a period of 90 days or more unless the loan is both well securedand in the process of collection.

 

Weidentify a loan as impaired when it is probable that interest and/or principalwill not be collected according to the contractual terms of the loan agreement.ASC 310-10-35, “Receivables,” requires us to individually examine loans whereit is probable that we will be unable to collect all contractual interest andprincipal payments according to the contractual terms of the loan agreement andassess for impairment. The average recorded investment in the March 31,2010 and December 31, 2009 impaired loans was $37.9 million and $25.2 million,respectively.  For the three monthsending March 31, 2010, interest income recognized during the time withinthe period that the loans were impaired was $229 thousand. The Bank’s policiesrequire loan officers to regularly review accounts. Consistent with OCCguidance appraisals are updated as warranted based on specific facts andcircumstances. Appraisals are also updated whenever a loan becomes criticizedor classified.

 

Thefollowing charts present additional information about impaired loans and leasebalances as of March 31, 2010 and December 31, 2009:

 

March 31, 2010

 
| ** **                                  | ** ** | ** **  | ** ** | ** **       | ** ** | **Number of** | ** ** | **Specific**    | ** ** |
|---------------------------------------------|------------|-------------|------------|------------------|------------|---------------|------------|-----------------|------------|
| ** **                                  | ** ** | **Loan**    | ** ** | **Impaired**     | ** ** | **Impaired**  | ** ** | **Allowance**   | ** ** |
| **(Dollars  in thousands)**                 | ** ** | **Balance** | ** ** | **Loan Balance** | ** ** | **Loans**     | ** ** | **on Impaired** | ** ** |
|                                        |       |        |       |             |       |          |       |            |       |
| Commercial loans                            |       | $           | 324,126    |             | $          | 14,632        |       | 47              |       | $ | 1,105 |   |
| Real estate — commercial               |       | 259,388     |       | 13,009           |       | 11            |       | 3,563           |       |
| Real estate — commercial construction  |       | 62,430      |       | 11,871           |       | 11            |       | 780             |       |
| Real estate — residential              |       | 92,029      |       | 1,750            |       | 6             |       | 347             |       |
| Real estate — residential construction |       | 28,059      |       | 1,449            |       | 4             |       | 523             |       |
| Consumer loans                              |       | 116,902     |       | 2,319            |       | 35            |       | 1,028           |       |
| Lease financing receivables                 |       | 1,335       |       | 152              |       | 5             |       | 152             |       |
|                                        |       |        |       |             |       |          |       |            |       |
| Totals                                      |       | $           | 884,269    |             | $          | 45,182        |       | 119             |       | $ | 7,498 |   |

 

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December 31, 2009

 
| ** **                                  | ** ** | ** **  | ** ** | ** **       | ** ** | ** **    | ** ** | **Specific**    | ** ** |
|---------------------------------------------|------------|-------------|------------|------------------|------------|---------------|------------|-----------------|------------|
| ** **                                  | ** ** | ** **  | ** ** | ** **       | ** ** | **Number of** | ** ** | **Allowance**   | ** ** |
| ** **                                  | ** ** | **Loan**    | ** ** | **Impaired**     | ** ** | **Impaired**  | ** ** | **on Impaired** | ** ** |
| **(Dollars  in thousands)**                 | ** ** | **Balance** | ** ** | **Loan Balance** | ** ** | **Loans**     | ** ** | **Loans**       | ** ** |
|                                        |       |        |       |             |       |          |       |            |       |
| Commercial loans                            |       | $           | 334,286    |             | $          | 13,269        |       | 35              |       | $ | 1,029 |   |
| Real estate — commercial               |       | 261,643     |       | 12,071           |       | 11            |       | 3,637           |       |
| Real estate — commercial construction  |       | 66,204      |       | 8,786            |       | 8             |       | 135             |       |
| Real estate — residential              |       | 88,024      |       | 2,601            |       | 7             |       | 644             |       |
| Real estate — residential construction |       | 29,387      |       | 2,137            |       | 7             |       | 874             |       |
| Consumer loans                              |       | 120,767     |       | 2,596            |       | 42            |       | 1,148           |       |
| Lease financing receivables                 |       | 1,578       |       | 167              |       | 8             |       | 55              |       |
|                                        |       |        |       |             |       |          |       |            |       |
| Totals                                      |       | $           | 901,889    |             | $          | 41,627        |       | 118             |       | $ | 7,522 |   |

 

**NON-INTERESTINCOME**

 

Totalnon-interest income from continuing operations decreased $1.4 million to $1.0million for the three months ended March 31, 2010, compared to $2.4million for the same period in 2009.

 

InJune 2010, the Corporation sold eight OREO properties to one buyer. A charge of$1.3 million was recorded during the first quarter 2010 to reduce the carryingamount of these assets to an amount that reflects the realizable value of theseproperties based on the actual sales price.

 

TheCorporation has operating lease agreements with one customer.  The income on these leases is classified as “RentalIncome.”  Rental Income on operatinglease agreements for the three-month period ended March 31, 2010 was $257thousand a decrease of $83 thousand or 24.4% from 340 thousand during the sameperiod in 2009.

 

**NON-INTERESTEXPENSE**

 

Totalnon-interest expense from continuing operations dereased $142 thousand or 1.5%to $9.6 million for the three-month period ended March 31, 2010, comparedto $9.8 million during the same period in 2009.

 

Professional servicesexpense from continuing operations increased $1.2 million to $1.8 million forthe three-month period ended March 31, 2010 when compared to the sameperiod in 2009.  The increase wasprimarily due to the increased legal, audit and consulting fees related to themerger with Tower Bank and the restatement of 2009 SEC filings.

 

FDICinsurance premiums increased $257 thousand or 62.2% to $670 thousand for thethree month period ended March 31, 2010 when compared to the same periodin 2009.  During 2008 and 2009, the FDICadopted rules that increased FDIC premiums significantly for all banks forassessment periods beginning in the first quarter of 2009.

 

Offsettingthese increase in non-interest expenses, salaries and employee benefits fromcontinuing operations decreased $1.7 million to $3.6 million for thethree-month period ended March 31, 2010 compared to $5.2 million for thesame period in 2009.  The primary driverof this reduction was the fourth quarter 2009 reduction in force.

 

I**NCOME TAXES**

 

TheCorporation has not recorded an income tax benefit for its net operating lossfor the three month period ended March 31, 2010. At March 31, 2010the valuation allowance against the Corporation’s deferred tax asset increasedto $8.7 million from $7.5 million at December 31, 2009. The valuationallowance is recorded against a portion of the Corporation’s deferred taxassets after concluding that it was more likely than not that a portion of thedeferred tax asset would not be realized. In evaluating the ability to recoverour deferred tax assets, Management considers all available positive andnegative evidence regarding the ultimate realizability of our deferred taxassets including past operating results and our forecast of future taxableincome. In addition, general uncertainty surrounding the future economic andbusiness conditions have increased the likelihood of volatility in our futureearnings. The Corporation has concluded and recorded a valuation allowanceagainst its deferred tax asset, except for amounts available for carrybackclaims.

 

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**LIQUIDITYMANAGEMENT AND INTEREST RATE SENSITIVITY**

 

**LiquidityManagement**

 

Theobjective of liquidity management is to ensure the availability of sufficientcash flows to meet all financial commitments. Liquidity management addresses the Corporation’s ability to meet depositwithdrawals either on demand or at contractual maturity, to repay borrowings asthey mature and to make new loans and investments as opportunities arise.  Liquidity is managed on a daily basisenabling management to monitor changes in liquidity and to react accordingly tofluctuations in market conditions.  Theprimary sources of liquidity for the Corporation are funding available from thegrowth of the existing deposit base, new deposits, FHLB, Federal Reserve andcash flow from the investment and loan portfolios.  The Corporation considers funds from suchsources to comprise its “core” funding sources because of the historicalstability of such sources of funds. Additional liquidity comes from the Corporation’s creditfacilities.  Other deposit sourcesinclude a tiered savings product and certificates of deposit in excess of$100,000. Details of core deposits, non-interest bearing demand depositaccounts, and other deposit sources are highlighted in the following table andinclude aggregated amounts from both continuing and discontinued operations:

 
| ** **                           | ** ** | **For the Three Months Ended  March 31, 2010** | ** ** | **For the Year Ended  December 31, 2009** | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                           | ** ** | **Average**                                         | ** ** | **Effective**                                  | ** ** | **Average** | ** ** | **Effective** | ** ** |
| **(Dollars  in thousands)**          | ** ** | **Balance**                                         | ** ** | **Yield**                                      | ** ** | **Balance** | ** ** | **Yield** | ** ** |
| **DEPOSIT TYPE**                     |       |                                                |       |                                           |       |   |   |   |   |
| NOW Accounts                         |       | $                                                   | 227,091    |                                           | 0.46       | % | $ | 193,760 |   | 0.78 | % |
| Money Market                         |       | 113,995                                             |       | 1.09                                           | %          | 158,668 |   | 1.17 | % |
| Statement Savings                    |       | 37,939                                              |       | 0.46                                           | %          | 40,198 |   | 0.55 | % |
| Other Savings                        |       | 2,179                                               |       | 0.93                                           | %          | 1,946 |   | 0.96 | % |
| Tiered Savings                       |       | 49,469                                              |       | 0.94                                           | %          | 46,650 |   | 1.05 | % |
| Total NOW Savings, and Money Market  |       | 430,673                                             |       | 0.68                                           | %          | 441,222 |   | 0.93 | % |
|                                 |       |                                                |       |                                           |       |   |   |   |   |
| CDs Less than $100,000               |       | 275,018                                             |       | 2.09                                           | %          | 276,274 |   | 2.55 | % |
| CDs Greater than $100,000            |       | 216,625                                             |       | 2.09                                           | %          | 152,891 |   | 2.66 | % |
| Total CDs                            |       | 491,643                                             |       | 2.09                                           | %          | 429,165 |   | 2.59 | % |
|                                 |       |                                                |       |                                           |       |   |   |   |   |
| Total Interest Bearing Deposits      |       | 922,316                                             |       | 1.43                                           | %          | 870,387 |   | 1.75 | % |
|                                 |       |                                                |       |                                           |       |   |   |   |   |
| Non-Interest Bearing Demand Deposits |       | 150,729                                             |       | —                                         |       | 149,967 |   | — |   |
|                                 |       |                                                |       |                                           |       |   |   |   |   |
| Total Deposits                       |       | $                                                   | 1,073,045  |                                           |       |   | $ | 1,020,354 |   |   |   |

 

TheBank maintains several credit facilities with the FHLB as well as the FederalReserve and other banking institutions. During the first quarter of 2010, average FHLB advances were $116.7million and consisted of term advances with a variety of maturities.  The average interest rate on these advanceswas 3.49%.  The Bank currently has amaximum borrowing capacity with FHLB of approximately $60.0 million.  FHLB advances are collateralized by a pledgeon the Bank’s portfolio of certain mortgage loans and a lien on the Bank’s FHLBstock.  In addition, the Bank has backuplines of credit available from other financial institutions, as well as theFederal Reserve, totaling approximately $203.7 million. Federal Reserveborrowings are collateralized by a pledge on certain commercial and commercialreal estate loans and a lien on the Bank’s Federal Reserve stock.

 

**InterestRate Sensitivity**

 

Thegoal of interest rate sensitivity management is to avoid fluctuating netinterest margins, and to enhance consistent growth of net interest incomethrough periods of changing interest rates. Such sensitivity is measured as the difference in the volume of assetsand liabilities in the existing portfolio that are subject to repricing in afuture time period.  The Corporation’snet interest rate sensitivity gap within one year including assets andliabilities of discontinued operations is a negative $108.1 million or 8.4% oftotal assets at March 31, 2010.  TheCorporation’s 

 

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gapposition is one tool used to evaluate interest rate risk and the stability ofnet interest margins.  Another tool thatmanagement uses to evaluate interest rate risk is a computer simulation modelthat assesses the impact of changes in interest rates on net interest incomeunder various interest rate forecasts and scenarios.  Management has set acceptable limits of riskwithin its Asset Liability Committee policy and monitors the results of thesimulations against these limits quarterly. As of the most recent quarter-end, results are within policy limits andindicate an acceptable level of interest rate risk, except rate simulationsquantifying the impact of an interest rate declines of 200 and 300 basis points.Given the historically low rate levels the Bank is currently operating in, Managementbelieves it is very unlikely interest rates would decline 200 basis points ormore in the future. Management monitors interest rate risk as a regular part ofcorporate operations****with theintention of maintaining a stable net interest margin. The following tablepresents our interest rate sensitivity analysis as of March 31, 2010, andincludes aggregated amounts from both continuing and discontinued operations:

 
| ** **                                                        | ** ** | ** **       | ** ** | **Two**            | ** ** | **Over**      | ** ** | ** **        | ** ** | ** **    | ** ** |
|-------------------------------------------------------------------|------------|------------------|------------|--------------------|------------|---------------|------------|-------------------|------------|---------------|------------|
| ** **                                                        | ** ** | **Within**       | ** ** | **through**        | ** ** | **five**      | ** ** | **Non-rate**      | ** ** | ** **    | ** ** |
| **(Dollars  in thousands)**                                       | ** ** | **one year (1)** | ** ** | **five years (1)** | ** ** | **Years (1)** | ** ** | **Sensitive (1)** | ** ** | **Total (1)** | ** ** |
| ASSETS                                                            |       |             |       |               |       |          |       |              |       |          |       |
| Federal funds sold and overnight investments                      |       | $                | 1,062      |               | $          | —        |       | $                 | —     |          | $          | — |   | $ | 1,062 |   |
| Investment securities                                             |       | 30,145           |       | 14,704             |       | 20,447        |       | —            |       | 65,296        |       |
| Interest bearing deposits in banks                                |       | 189,534          |       | —             |       | —        |       | —            |       | 189,534       |       |
| Loans held for sale                                               |       | 103,277          |       | —             |       | —        |       | —            |       | 103,277       |       |
| Net loans and leases                                              |       | 364,736          |       | 366,733            |       | 152,800       |       | (22,464           | )          | 861,805       |       |
| Cash and due from banks                                           |       | —           |       | —             |       | —        |       | 16,866            |       | 16,866        |       |
| Premises and equipment                                            |       | —           |       | —             |       | —        |       | 21,641            |       | 21,641        |       |
| Other assets                                                      |       | —           |       | —             |       | —        |       | 33,484            |       | 33,484        |       |
| Total assets                                                      |       | $                | 688,754    |               | $          | 381,437       |       | $                 | 173,247    |          | $          | 49,527 |   | $ | 1,292,965 |   |
|                                                              |       |             |       |               |       |          |       |              |       |          |       |
| LIABILITIES AND CAPITAL                                           |       |             |       |               |       |          |       |              |       |          |       |
| Non-interest bearing deposits                                     |       | $                | —     |               | $          | —        |       | $                 | —     |          | $          | 153,601 |   | $ | 153,601 |   |
| Interest bearing deposits                                         |       | 694,255          |       | 221,424            |       | 3,560         |       | —            |       | 919,239       |       |
| FHLB advances and other Borrowings                                |       | 87,095           |       | 40,679             |       | 2,480         |       | —            |       | 130,254       |       |
| Subordinated debentures                                           |       | 15,465           |       | —             |       | 5,330         |       | —            |       | 20,795        |       |
| Other liabilities                                                 |       | —           |       | —             |       | —        |       | 14,205            |       | 14,205        |       |
| Capital                                                           |       | —           |       | —             |       | —        |       | 54,871            |       | 54,871        |       |
| Total liabilities & capital                              |       | $                | 796,815    |               | $          | 262,103       |       | $                 | 11,370     |          | $          | 222,677 |   | $ | 1,292,965 |   |
| Net interest rate sensitivity gap                                 |       | $                | (108,061   | )                  | $          | 119,334       |       | $                 | 161,877    |          | $          | (173,150 | ) |   |   |
| Cumulative interest rate sensitivity gap                          |       | $                | (108,061   | )                  | $          | 11,273        |       | $                 | 173,150    |          | $          | — |   |   |   |
| Cumulative interest rate sensitivity gap divided  by total assets |       | (8.4             | )%         | 0.09               | %          | 13.4          | %          |              |       |          |       |

 

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(1)          Amounts above are shownconsolidated and do not exclude the balances related to the mortgage bankingdivision’s discontinued operations. Presentation with the exclusion of these balance sheet amounts wasdeemed not meaningful by management.

 

Thenature of our current operations is such that we are not subject to foreigncurrency exchange or commodity price risk. However, the Bank is subject tointerest rate risk with respect to its mortgage banking division. When the Bankcontractually commits with a customer to an interest rate on a residentialmortgage loan that it intends to sell, the Bank may be at risk that the valueof the loan, when ultimately sold, will be less than par. To hedge this risk,the Bank enters into a derivative contract, primarily consisting of forwardloan sale commitments. Additionally, our liquidity planning takes into accountcurrent risks in our mortgage banking operations. We sell residential mortgageloans to various secondary market investors under several agreements. In theevent we breach certain requirements within these agreements, the investorshave the ability to suspend or terminate the agreements. A suspension ortermination could expose us to interest rate and liquidity risk, and also limitour ability to manage our balance sheet size and maintain compliance withregulatory capital guidelines. We are currently in default under theseagreements due to our failure to file our audited financial statements withinthe specified timeframe, our failure to satisfy the IMCRs, and in certain casesthe inclusion of a “going concern” explanatory paragraph in the auditors’report regarding the consolidated financial statements. To date, two of theinvestors under these agreements have terminated their agreements with us.Additionally, other investors, to whom we sell nearly 88% of our loanproduction, have verbally indicated that although we are in breach of the abovementioned requirements, they will forebear the defaults for an unspecifiedperiod of time.

 

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**CAPITAL****ADEQUACY**

 

We are subject to Risk-BasedCapital Guidelines adopted by the Federal Reserve for bank holding companies.The Bank is also subject to similar capital requirements adopted by the OCC.Under these requirements, the regulatory agencies have set minimum capitalratio thresholds. To be considered “well capitalized” banks must generallymaintain a Tier I leverage ratio of at least 5%, a Tier 1 risk-based capitalratio of at least 6% and a total risked-based capital ratio of at least 10%.During the fourth quarter of 2009, the OCC advised management that the OCC hadestablished new higher capital ratio requirements on the Bank (individualminimum capital ratios, or IMCRs) thereby requiring the Bank to maintain itsTier 1 leverage ratio at not less than 8%, its Tier 1 risk-based capital ratioat not less than 10% and its total risk-based capital ratio at not less than12%. The Bank was required to achieve these new higher levels by December 31,2009.

 

Our efforts to raise capitalbefore the OCC’s deadline consummated in the definitive merger agreement withTower Bancorp. As part of the merger agreement, Graystone Tower Bank increasedour loan from $4 million, which was entered into on November 20, 2009, toup to a maximum of $26 million. We used the increased proceeds to make acapital contribution to the Bank in an effort to satisfy the capitalrequirements established by the OCC. The loan, as modified, is a non-revolvingone year term loan bearing interest at the rate of 6% per annum, and is securedby a pledge of all of the common stock of the Bank. Additionally, under thedefinitive merger agreement, Graystone purchased $52.5 million in first lienresidential real estate and commercial loan participations at a 1.5% discountin effort to assist the Bank in satisfying the IMCRs.

 

As of March 31, 2010,the Bank met the IMCR threshold for Tier 1 risk-based capital and totalrisk-based capital, but was below the IMCR thresholds for Tier 1 leverage.  The OCC may deem the Bank’s noncompliance tobe an unsafe and unsound banking practice which may subject the Bank to acapital directive, a consent order, or such other administrative actions orsanctions as the OCC considers necessary. It is uncertain what actions, if any,the OCC would take with respect to noncompliance with these ratios, what actionsteps the OCC might require the Bank to take to remedy this situation, andwhether such actions would be successful. The Corporation’s and Bank’srisk-based capital ratios, shown below, have been computed in accordance withregulatory accounting policies.

 
| ** **                     | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **Current Requirements to  remain “Well  Capitalized”** | ** ** |
|--------------------------------|------------|--------------------|------------|-----------------------|------------|------------------------------------------------------------------------|------------|
| ** **                     | ** ** | **2010**           | ** ** | **2009**              | ** ** | **Requirements (*)**                                                   | ** ** |
| Corporation                    |       |               |       |                  |       |                                                                   |       |
| Leverage Ratio                 |       | 5.61               | %          | 5.71                  | %          | N/A                                                                    |       |
| Tier I Capital Ratio           |       | 8.15               | %          | 7.79                  | %          | N/A                                                                    |       |
| Total Risk-Based Capital Ratio |       | 9.65               | %          | 9.16                  | %          | N/A                                                                    |       |
| Bank                           |       |               |       |                  |       |                                                                   |       |
| Leverage Ratio                 |       | 7.71               | %          | 7.68                  | %          | 8.00                                                                   | %          |
| Tier I Capital Ratio           |       | 11.22              | %          | 10.47                 | %          | 10.00                                                                  | %          |
| Total Risk-Based Capital Ratio |       | 12.48              | %          | 11.74                 | %          | 12.00                                                                  | %          |

 

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(*)           Ratios imposed by the OCC under the IMCRs.

 

**REGULATORYMATTERS**

 

On October 16, 2009, the Board of Directors of the Bank enteredinto an MOU with the OCC.  An MOU with regulatory authorities is aninformal action that is not published or publicly available and that is usedwhen circumstances warrant a milder form of action than a formal supervisoryaction, such as a formal written agreement or order. Among other things, underthe MOU, the Bank has agreed to address the following matters:

 

·                  Develop a comprehensive three-year capitalplan;

 

·                  Take action to protect criticized assets andadopt and implement a program to eliminate the basis of criticism of suchassets;

 

·                  Establish an effective program that providesfor early problem loan identification and a formal plan to proactively managethose assets;

 

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·                  Review the adequacy of the Bank’s informationtechnology activities and Bank Secrecy Act compliance and approve writtenprograms of policies and procedures to provide for compliance; and

 

·                  Establish a Compliance Committee of the Boardto monitor and coordinate the Bank’s adherence to the provisions of the MOU.

 

The Board of Directors and management havealready initiated corrective actions to comply with the provisions of the MOU.

 

**ITEM 3.  QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

Therehave been no material changes in the Corporation’s assessment of itssensitivity to market risk since its presentation in the 2009 Annual Report.Please refer to Item 7A of the Corporation’s 2009 Annual Report for moreinformation.

 

**ITEM 4.  CONTROLS AND PROCEDURES**

 

**DisclosureControls and Procedures**

 

Asof March 31, 2010, the end of the period covered by this Quarterly Reporton Form 10-Q, an evaluation of the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13(a)-15(e) and15(d)-5(e) promulgated under the Securities Exchange Act of 1934, asamended (the “Exchange Act”)) was performed under the supervision and with theparticipation of management, including our President and CEO, Chief OperatingOfficer and our Chief Financial Officer. Based on that evaluation and theidentification of the material weakness in our internal control over financialreporting as described below, management has concluded that our disclosurecontrols and procedures were not effective to ensure that information requiredto be disclosed by us in the reports that we file or submit under the ExchangeAct is (i) recorded, processed, summarized and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms, and (ii) accumulated and communicated to management as appropriateto allow timely decisions regarding required disclosures.

 

**Changes in Internal Control overFinancial Reporting**

 

As reported in our 2009Annual Report, management conducted a thorough and methodical evaluation andtesting of our internal controls over financial reporting as of December 31,2009, which resulted in the identification of three material controlweaknesses.  Management continues theirongoing efforts to correct and revise the existing processes surrounding thesematerial weaknesses and additional changes will be implemented as determinednecessary.

 

*Allowancefor Loan and Lease Losses*

 

During the third quarter of2009, management identified a material weakness in our internal controlsrelated to the design and implementation of policies to promptly identifyproblem loans and to quantify the elements of risk in problem loans. The Bank’spolicies and procedures were not systematically applied, which caused a failurein the identification of problem loans on a timely basis and a failure toaccurately estimate the risk in the portfolio; this in turn caused a failure toaccurately determine the appropriate allowance for loan and lease losses (‘‘ALLL’’).We also discovered a monitoring weakness that contributed to thecharacterization of the status of certain loans to be classified as fullyperforming, when in fact these loans were not. Management concluded that theALLL and the provision for loan and lease losses as of and for the three andsix months ended June 30, 2009 should be increased by $3.5 million. As aresult of the June 30, 2009 ALLL shortfall of $3.5 million, amountsoriginally recorded as provision for loan and lease losses for the three monthsended September 30, 2009 were restated to the three month period ended June 30,2009. This restatement created a material misstatement in the consolidatedstatements of operations for the three months ended September 30, 2009, aswell as related footnote disclosures. During the fourth quarter of 2009 andsubsequent to year-end, we began taking the steps described below to remediatethe material weakness surrounding the ALLL as disclosed in our Amendment No. 1to Form 10-Q/A for the periods ended June 30, 2009 and September 30,2009.

 

*Mark-to-MarketAccounting of Mortgage Loans Held for Sale*

 

Subsequent to year-end,management identified a material weakness in internal controls related to ourprocess to review the valuation of mortgage loans held for sale. Mortgage loansheld for sale represent mortgage loans originated by us and held until sold tosecondary market investors. Upon the closing of a residential mortgage loan 

 

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originated by us, themortgage loan is typically warehoused for a period of time and then sold intothe secondary market. While in this warehouse phase, mortgage loans held forsale are recorded at fair value under the fair value option with changes infair value recognized through earnings. An error was identified in our processto properly identify a certain population of loans held for sale prior tosending the loan details to our third party valuation firm. As such, weerroneously excluded from the population to be fair valued, loans which wereidentified for sale but for which we were awaiting the consideration from thecounterparty to complete the sales transaction. These particular loans werecorrectly classified as loans held for sale on the consolidated balance sheet;however, the unrealized gain associated with these loans was not reflected inthe consolidated balance sheet and the statement of operations. This errorresulted in an understatement in the carrying amount of loans held for sale forthe quarters ended March 31, June 30 and September 30, 2009, aswell as an understatement of net income for each quarter. As a result of thismaterial weakness, the Bank increased net gains from mortgage banking by $1.2million, $14 thousand and $2.7 million for the quarters ended March 31, June 30,and September 30, 2009, respectively. Additionally, in April 2010,management discovered another process error relating to the accounting for themark-to-market of mortgage loans held for sale, which produced an additionalincrease in net gains from mortgage banking of $215 thousand as of December 31,2009, which was correctly reflected in our financial statements for the yearended December 31, 2009. Accordingly, management concluded that thesedeficiencies constitute a material weakness in internal controls related to ourprocess to review the valuation of mortgage loans held for sale.

 

*SubsequentEvents*

 

In May 2010, managementdiscovered an error related to our process of reviewing, accounting for and thereporting of subsequent events, which resulted in the improper application ofGAAP. Specifically, $6.7 million of the provision for loan and lease losses,which was recorded subsequent to December 31, 2009, should have beenrecorded as of December 31, 2009. This error was correctly reflected inour financial statements for the year ended December 31, 2009.

 

***Remediation of Material Weaknesses***

 

*Allowancefor Loan and Lease Losses*

 

During the fourth quarter2009 and subsequent to year-end, management began taking steps to remediate thematerial weakness surrounding the Allowance for Loan and Lease Losses. Thefollowing steps have been completed as of the time of this filing:

 

·                  hired aseasoned Credit Administration and Credit Policy Officer to oversee, manage andtrain lending personnel

 

·                  engaged anindependent third party to perform the quarterly loan review process, whichincludes 100% coverage of criticized and classified assets;

 

·                  approved andimplemented separation of lending and credit administration functions toincrease internal controls and improve segregation of duties;

 

·                  conducted riskrecognition training to improve criticized asset management and to ensure properevaluation of ongoing credit ratings;

 

·                  improvedprocesses for identifying impaired loans and the determination of the amount ofimpairment in accordance with OCC guidelines;

 

·                  approved andimplemented change of lending authorities to ensure better oversight of lendersand to increase oversight on criticized assets;

 

·                  approved andimplemented Board of Director approval for all new credit advances forcriticized assets of $1,000,000 or greater;

 

·                  transferredresponsibilities for management and oversight of the Loan Quality Committee,Loan Committee, Delinquency Committee and Classified Asset Committee to aseparate Credit Administration and Credit Policy Officer; and

 

·                  the Loan ReviewCommittee shall continue to review the Loan Quality Status Reports on aquarterly basis.

 

Management continues toreview existing policies, procedures and practices for compliance with riskrating, accountability and timeliness regarding credit administration, riskrecognition, credit management and credit assessment.

 

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*Mark-to-MarketAccounting of Mortgage Loans Held for Sale*

 

Subsequent to December 31,2009, and immediately following management’s identification of the materialweakness surrounding the mark-to-market accounting of Mortgage Loans Held forSale, management enhanced an existing process that will ensure the portfolio ofMortgage Loans Held for Sale is complete prior to delivery to the third partyvaluation firm. At each month-end a reconciliation is performed to ensure theloans held for sale included in the file sent to the third party valuation firmreconciles to our internal subledger. This internal subledger of loans held forsale is reconciled to our general ledger. These reconciliations are reviewed bymanagement monthly to ensure timely completion and that reconciling items, ifany, are appropriately addressed.

 

*SubsequentEvents*

 

Management has created andimplemented procedures to review and evaluate events occurring after the end ofeach quarter, but prior to issuing financial statements, to determine if thereis any impact on the quarterly or annual financial statements. As of the dateof this report, management is continuing their ongoing efforts to correct,revise and test the processes surrounding the material weaknesses describedabove. Additional changes will be implemented as determined necessary.

 

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**PART II - OTHER INFORMATION**

 

**ITEM 1.  LEGAL PROCEEDINGS**

 

Thereare no material pending legal proceedings, other than ordinary routinelitigation incidental to the business, to which the Corporation, or any of itssubsidiaries, is a party or of which any of their respective property is thesubject.

 

**ITEM 1A.  RISK FACTORS**

 

Fora summary of risk factors relevant to our operations, see Part 1, Item1A, “Risk Factors” in our 2009 Annual Report on Form 10-K for the yearended December 31, 2009.  There havebeen no material changes in the risk factors relevant to our operations, exceptas discussed below:

 

**Compliancewith the recently enacted Dodd-Frank Reform Act may increase our costs ofoperations and adversely impact our earnings.**

 

On July 21,2010, President Obama signed the Dodd-Frank Wall Street Reform and ConsumerProtection Act (the “Dodd-Frank Act”) into law.  The Dodd-Frank Actrepresents a significant overhaul of many aspects of the regulation of thefinancial-services industry.  Among other things, the Dodd-Frank Actcreates a new federal financial consumer protection agency, tightens capitalstandards, imposes clearing and margining requirements on many derivatives activities,and generally increases oversight and regulation of financial institutions andfinancial activities.  In addition to the self-implementing provisions ofthe statute, the Dodd-Frank Act calls for many administrativerulemakings by various federal agencies to implement various parts of thelegislation.  It is impossible to predictwhen any final rules would be issued through any such rulemakings, andwhat the content of such rules will be.  The financial reformlegislation and any implementing rules that are ultimately issued couldhave adverse implications on the financial industry, the competitiveenvironment, and our business. We will have to apply resources to ensure thatwe are in compliance with all applicable provisions of the Dodd-Frank Act andany implementing rules, which may increase our costs of operations andadversely impact our earnings.

 

**ITEM 2.  UNREGISTERED SALES OFEQUITY SECURITIES AND USE OF PROCEEDS**

 

The following table providesthe total repurchases made by the Company during the three months ended March 31,2010:

** **
| **Period**                                 | ** ** | **Total  Number of  Shares (or  Units)  Purchased  (a) (1)** | ** ** | **Average  Price Paid  per Share  (or Unit)  (b) (1)** | ** ** | **Total  Number of  Shares (or Units)  Purchased as Part  of Publicly Announced  Plans  or Programs  (c)** | ** ** | **Maximum  Number (or  Approximate Dollar Value) of  Shares (or Units) that May Yet  Be Purchased Under the Plans  or Programs  (d)** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------|------------|
| January 1  to January 31, 2010   |       | 3,310                                                             |       | $                                                           | 9.85       |                                                                                                       | —     |                                                                                                                                       | —     |   |
| February 1  to February 28, 2010 |       | 2,016                                                             |       | $                                                           | 10.07      |                                                                                                       | —     |                                                                                                                                       | —     |   |
| March 1  to March 31, 2010       |       | 9,917                                                             |       | $                                                           | 10.34      |                                                                                                       | —     |                                                                                                                                       | —     |   |
| Total                                      |       | 15,243                                                            |       | $                                                           | 10.09      |                                                                                                       | —     |                                                                                                                                       | —     |   |

 

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(1)         Pursuant to the trustagreement between the Corporation and the trustee, these shares wererepurchased from our 401(k) Plan. The purchase price was the averagebetween the bid and the ask on the repurchase date.

 

**ITEM 3.  DEFAULTS UPON SENIORSECURITIES**

 

None.

 

**ITEM 4.  [REMOVED AND RESERVED.]**

 

**ITEM 5.  OTHER INFORMATION**

 

None.

 

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**ITEM 6.  EXHIBITS**

 

Theexhibits required to be filed as part of this Quarterly Report on Form 10-Qare listed in the Exhibit Index attached hereto and are incorporatedherein by reference.

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized on August 11, 2010.

 

**FIRSTCHESTER COUNTY CORPORATION**

 
|   | /s/  John A. Featherman, III                       |
|--------|---------------------------------------------------------|
|   | John  A. Featherman, III                           |
|   | Chairman,  Chief Executive Officer & President |
|   | (Principal  Executive Officer)                          |
|   |                                                    |
|   | /s/  Eric A. Segal                                      |
|   |                                                    |
|   | Interim  Chief Financial Officer                        |
|   | (Principal  Financial and Accounting Officer)           |

 

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**INDEXTO EXHIBITS**

** **
| **Exhibit Number** | ** ** | **Exhibit**                                                                                                                                                                                                                  |
|-------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                     |       | Amended  Articles of Incorporation (incorporated herein by reference to  Exhibit 3.1 to the Corporation’s Quarterly Report on Form 10-Q for  the quarter ended March 31, 2004, filed May 14, 2004.) |
| 3.2                     |       | Amendment  to the Articles of Incorporation (incorporated herein by reference to  Exhibit 3.2 to the Corporation’s Form 8-A, filed October 22,  2009.)                                                   |
| 3.3                     |       | Amended  and Restated Bylaws (incorporated herein by reference to Exhibit 3.3 to  the Corporation’s Form 8-A, filed October 22, 2009.)                                                                   |
| 31.1                    |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |
| 31.2                    |       | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |
| 32.1                    |       | Certification  of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |
| 32.2                    |       | Certification  of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002*                                                                                                                   |

 

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*Filed herewith.

 

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