**FORM 10-Q**

 

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

(Mark One)

 

| (**X**) | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE |
|---------|----------------------------------------------------------|

SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended**September 30, 2008**, OR

 

| ( ) | 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 as specified in its charter)

 

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

 

**9 North High Street, West Chester, Pennsylvania                              19380**

|   | (Address of principal executive office) |       (Zip code) |
|--------|-----------------------------------------|-------------------------------------------|

 

**(484) 881-4000**

(Registrant’s telephone number, including area code)

 

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

 

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b- of the

Exchange Act). Yes      No X 

 

The nuber of shares outstanding of Common Stock of the Registrant as of November 10, 2008 was 5,188,205.

 

| Part I. | FINANCIAL INFORMATION |                                                                         |
|---------|-----------------------|------------------------------------------------------------------------------|
|    |                  |                                                                         |   |
|    | Item 1 -              | Financial Statements                                                         |   |
|    |                  | Consolidated Balance Sheet                                                   |   |
|    |                  | September 30, 2008 (unaudited) and December 31, 2007                         | 3 |
|    |                  |                                                                         |   |
|    |                  | Consolidated Statements of Income                                            |   |
|    |                  | Three and Nine Months Ended September 30, 2008 and 2007 (unaudited)          | 4 |
|    |                  |                                                                         |   |
|    |                  | Consolidated Statements of Cash Flows                                        |   |
|    |                  | Nine-Months Ended September 30, 2008 and 2007 (unaudited)                    | 5 |
|    |                  |                                                                         |   |
|    |                  | Consolidated Statements of  Changes in  Stockholders’ Equity |   |
|    |                  | Nine-Months Ended September 30, 2008 and 2007 (unaudited)                    | 6 |
|    |                  |                                                                         |   |
|    |                  | Notes to Consolidated Financial Statements                                   | 7-13 |
|    |                  |                                                                         |   |
|    | Item 2 -              | Management’s Discussion and Analysis of                                |   |
|    |                  | Financial Condition and Results of Operations                                | 14-31 |
|    |                  |                                                                         |   |
|    | Item 3 -              | Quantitative and Qualitative Disclosures About Market Risk                   | 32 |
|    |                  |                                                                         |   |
|    | Item 4 -              | Controls & Procedures                                                    |        32  |

 

| Part II. | OTHER INFORMATION |                                                        |
|----------|-------------------|-------------------------------------------------------------|
|     | Item 1 -          | Legal Proceedings                                           |  

33 |
|     |              |                                                        |   |
|     | Item 1A -         | Risk Factors                                                |  

33-39 |
|     |              |                                                        |   |
|     | Item 2 -          | Unregistered Sales of Equity Securities and Use of Proceeds |  

39 |
|     |              |                                                        |   |
|     | Item 3 -          | Defaults Upon Senior Securities                             | 40 |
|     |              |                                                        |   |
|     | Item 4 -          | Submission of Matters to a Vote of Security Holders         | 40 |
|     |              |                                                        |   |
|     | Item 5 -          | Other Information                                           | 40 |
|     |              |                                                        |   |
|     | Item 6 -          | Exhibits                                                    |  

41 |
|     |              |                                                        |   |
|     | Signatures        |                                                        |  

42 |
|     |              |                                                        |   |
|     | Index to Exhibits |                                                        | 43 |
|     |              |                                                        |   |
|     | Exhibits          |                                                        |   |

 

 

2

 

 

----

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. Financial Statements**

 

**CONSOLIDATED BALANCE SHEET**

 

| **(Dollars in thousands)**                                                                                                                       | **September 30,**                     |   |                                        |
|--------------------------------------------------------------------------------------------------------------------------------------------------|---------------------------------------|--------|---------------------------------------------|
|                                                                                                                                             | **2008**                              |   | **December 31,**                            |
|                                                                                                                                             | **(unaudited)**                       |   | **2007**                                    |
| ASSETS                                                                                                                                           |                                  |   |                                        |
| Cash and due from banks                                                                                                                          | $     43,210 |   | $      28,884 |
| Federal funds sold and other overnight investments                                                                                               | 14,581                                |   | 24,260                                      |
| Interest bearing deposits                                                                                                                        | 207                                   |   | 216                                         |
|                                                                                                                                             |                                  |   |                                        |
| Total cash and cash equivalents                                                                                                                  | 57,998                                |   | 53,360                                      |
|                                                                                                                                             |                                  |   |                                        |
| Investment securities available-for-sale, at fair value                                                                                          | 102,212                               |   | 97,977                                      |
|                                                                                                                                             |                                  |   |                                        |
| Loans and leases                                                                                                                                 | 808,931                               |   | 743,440                                     |
| Less: allowance for loan and lease losses                                                                                                        | (8,637)                               |   | (7,817)                                     |
|                                                                                                                                             |                                  |   |                                        |
| Net loans and leases                                                                                                                             | 800,294                               |   | 735,623                                     |
|                                                                                                                                             |                                  |   |                                        |
| Premises and equipment, net                                                                                                                      | 19,346                                |   | 17,560                                      |
| Net deferred tax asset                                                                                                                           | 6,410                                 |   | 4,418                                       |
| Bank owned life insurance                                                                                                                        | 10,203                                |   | -                                           |
| Other assets                                                                                                                                     | 5,733                                 |   | 5,843                                       |
| Total assets                                                                                                                                     | $  1,002,196                |   | $   914,781                  |
| LIABILITIES                                                                                                                                      |                                  |   |                                        |
| Deposits                                                                                                                                         |                                  |   |                                        |
| Non-interest-bearing                                                                                                                             | $    129,125      |   | $   124,199                  |
| Interest-bearing (including certificates of deposit over $100                                                                                    |                                  |   |                                        |
| of $78,707 and $58,816 at September 30, 2008 and                                                                                                 |                                  |   |                                        |
| December 31, 2007, respectively)                                                                                                                 | 632,394                               |   | 580,699                                     |
|                                                                                                                                             |                                  |   |                                        |
|                  Total deposits                                  | 761,519                               |   | 704,898                                     |
| Federal Home Loan Bank and other borrowings                                                                                                      | 148,585                               |   | 115,384                                     |
| Subordinated debt                                                                                                                                | 15,465                                |   | 15,465                                      |
| Other liabilities                                                                                                                                | 9,274                                 |   | 11,055                                      |
|                                                                                                                                             |                                  |   |                                        |
|                       Total liabilities | 934,843                               |   | 846,802                                     |
|                                                                                                                                             |                                  |   |                                        |
| STOCKHOLDERS’ EQUITY                                                                                                                       |                                  |   |                                        |
| Common stock, par value $1.00; authorized 25,000,000 shares;                                                                                     |                                  |   |                                        |
| Outstanding, 5,279,815 at September 30, 2008 and December 31, 2007                                                                               | 5,280                                 |   | 5,280                                       |
| Additional paid-in capital                                                                                                                       | 10,526                                |   | 11,113                                      |
| Retained earnings                                                                                                                                | 57,337                                |   | 55,347                                      |
| Accumulated other comprehensive loss                                                                                                             | (3,982)                               |   | (1,207)                                     |
| Treasury stock, at cost: 92,586 shares and 119,065 shares                                                                                        |                                  |   |                                        |
| at September 30, 2008 and December 31, 2007, respectively                                                                                        | (1,808)                               |   | (2,554)                                     |
|                                                                                                                                             |                                  |   |                                        |
| Total stockholders’ equity                                                                                                                 | 67,353                                |   | 67,979                                      |
|                                                                                                                                             |                                  |   |                                        |
| Total liabilities and stockholders’ equity                                                                                                 | $   1,002,196          |   | $   914,781                  |

 

 

The accompanying notes are an integral part of these statements.

 

3 

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF INCOME**

(**UNAUDITED**)

 

| **(Dollars in thousands - except per share)**   | **Three Months Ended**  | **Nine Months Ended** |
|-----------------------------------------------------------|------------------------------|-----------------------|

|   | **September 30,** | **September 30,** |
|--------|-------------------|-------------------|

 

|                                                                                                                                               | 2008                                      |   | 2007                                      |   | 2008                                      |   | 2007                                      |
|----------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------------------------|--------|-------------------------------------------|--------|-------------------------------------------|--------|-------------------------------------------|
| INTEREST INCOME                                                                                                                                    |                                      |   |                                      |   |                                      |   |                                      |
| Loans and leases, including fees                                                                                                                   | $   12,421                 |   | $   12,655                 |   | $   36,845                 |   | $   37,206                 |
| Investment securities                                                                                                                              | 1,255                                     |   | 1,050                                     |   | 3,836                                     |   | 3,100                                     |
| Federal funds sold and deposits in banks                                                                                                           | 200                                       |   | 676                                       |   | 1,068                                     |   | 1,920                                     |
| Total interest income                                                                                                                              | 13,876                                    |   | 14,381                                    |   | 41,749                                    |   | 42,226                                    |
| INTEREST EXPENSE                                                                                                                                   |                                      |   |                                      |   |                                      |   |                                      |
| Deposits                                                                                                                                           | 3,647                                     |   | 5,338                                     |   | 12,099                                    |   | 15,477                                    |
| Subordinated debt                                                                                                                                  | 209                                       |   | 321                                       |   | 683                                       |   | 1,155                                     |
| Federal Home Loan Bank and otherborrowings                                                                                                         | 1,470                                     |   | 731                                       |   | 4,390                                     |   | 1,950                                     |
| Total interest expense                                                                                                                             | 5,326                                     |   | 6,390                                     |   | 17,172                                    |   | 18,582                                    |
|                                                                                                                                               |                                      |   |                                      |   |                                      |   |                                      |
|                       Net interest income | 8,550                                     |   | 7,991                                     |   | 24,577                                    |   | 23,644                                    |
| Provision for loan and lease losses                                                                                                                | 290                                       |   | -                                         |   | 950                                       |   | -                                         |
| Net interest income after provision                                                                                                                |                                      |   |                                      |   |                                      |   |                                      |
| for loan and lease losses                                                                                                                          | 8,260                                     |   | 7,991                                     |   | 23,627                                    |   | 23,644                                    |
|                                                                                                                                               |                                      |   |                                      |   |                                      |   |                                      |
| NON-INTEREST INCOME                                                                                                                                |                                      |   |                                      |   |                                      |   |                                      |
| Wealth management and advisory services                                                                                                            | 994                                       |   | 987                                       |   | 3,069                                     |   | 3,033                                     |
| Service charges on deposit accounts                                                                                                                | 657                                       |   | 595                                       |   | 1,853                                     |   | 1,703                                     |
| Gains on sales of investment securities, net of 

losses                                                                                      | 89                                        |   | -                                         |   | 273                                       |   | 2                                         |
| Operating lease rental income                                                                                                                      | 328                                       |   | 326                                       |   | 967                                       |   | 949                                       |
| Gains (losses) on fixed assets and OREO                                                                                                            | (123)                                     |   | 1,376                                     |   | (33)                                      |   | 1,376                                     |
| Gain and fees on the sales of loans                                                                                                                | 33                                        |   | 118                                       |   | 197                                       |   | 537                                       |
| Bank owned life insurance                                                                                                                          | 46                                        |   | -                                         |   | 203                                       |   | -                                         |
| Asset impairment                                                                                                                                   | (1,267)                                   |   |                                      |   | (1,267)                                   |   |                                      |
| Other                                                                                                                                              | 570                                       |   | 488                                       |   | 1,693                                     |   | 1,481                                     |
| Total non-interest income                                                                                                                          | 1,327                                     |   | 3,890                                     |   | 6,955                                     |   | 9,081                                     |
|                                                                                                                                               |                                      |   |                                      |   |                                      |   |                                      |
| NON-INTEREST EXPENSE                                                                                                                               |                                      |   |                                      |   |                                      |   |                                      |
| Salaries and employee benefits                                                                                                                     | 4,847                                     |   | 4,755                                     |   | 13,845                                    |   | 14,348                                    |
| Occupancy, equipment and data processing                                                                                                           | 1,434                                     |   | 1,243                                     |   | 4,342                                     |   | 3,876                                     |
| Depreciation expense on operating leases                                                                                                           | 273                                       |   | 269                                       |   | 799                                       |   | 789                                       |
| Bank shares tax                                                                                                                                    | 207                                       |   | 160                                       |   | 592                                       |   | 481                                       |
| Professional services                                                                                                                              | 449                                       |   | 429                                       |   | 1,368                                     |   | 1,425                                     |
| Marketing                                                                                                                                          | 171                                       |   | 178                                       |   | 704                                       |   | 707                                       |
| Other                                                                                                                                              | 1,251                                     |   | 1,040                                     |   | 3,434                                     |   | 2,879                                     |
| Total non-interest expense                                                                                                                         | 8,632                                     |   | 8,074                                     |   | 25,084                                    |   | 24,505                                    |
| Income before income taxes                                                                                                                         | 955                                       |   | 3,807                                     |   | 5,498                                     |   | 8,220                                     |
| INCOME TAXES                                                                                                                                       | 148                                       |   | 1,030                                     |   | 1,329                                     |   | 2,288                                     |
| NET INCOME                                                                                                                                         | $    807              |   | $    2,777            |   | $    4,169            |   | $    5,932            |
| PER SHARE DATA                                                                                                                                     |                                      |   |                                      |   |                                      |   |                                      |
| Net income per share (Basic)                                                                                                                       | $      0.16 |   | $      0.54 |   | $      0.80 |   | $      1.15 |
| Net income per share (Diluted)                                                                                                                     | $      0.16 |   | $      0.53 |   | $      0.80 |   | $      1.14 |
| Dividends declared                                                                                                                                 | $    0.140            |   | $    0.135            |   | $    0.420            |   | $    0.405            |
|                                                                                                                                               |                                      |   |                                      |   |                                      |   |                                      |
| Basic weighted average shares outstanding                                                                                                          | 5,188,562                                 |   | 5,165,735                                 |   | 5,184,173                                 |   | 5,159,868                                 |
|                                                                                                                                               |                                      |   |                                      |   |                                      |   |                                      |
| Diluted weighted average shares outstanding                                                                                                        | 5,197,787                                 |   | 5,221,167                                 |   | 5,200,200                                 |   | 5,221,959                                 |

 

The accompanying notes are an integral part of these statements.

 

4

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

(**UNAUDITED**)

|   | **Nine Months Ended** |
|--------|-----------------------|

|   | **(Dollars in thousands)**   | **September30,** |
|--------|----------------------------------------|------------------|

 

|                                                                  | **2008**                                  |   | **2007**                                  |
|-----------------------------------------------------------------------|-------------------------------------------|--------|-------------------------------------------|
| OPERATING ACTIVITIES                                                  |                                      |   |                                      |
| Net income                                                            | $     4,169      |   | $     5,932      |
| Adjustments to reconcile net income to net cash                  |                                      |   |                                      |
| provided by operating activities:                                     |                                      |   |                                      |
| Depreciation                                                          | 1,848                                     |   | 1,908                                     |
| Provision for loan and lease losses                                   | 950                                       |   | -                                         |
| Amortization of investment security premiums                          |                                      |   |                                      |
| and accretion of discounts, net                                       | 250                                       |   | 151                                       |
| Amortization of deferred loan fees and costs                          | (570)                                     |   | (7)                                       |
| Gains on sales of investment securities, net                          | (273)                                     |   | (2)                                       |
| Gains from sales of fixed assets and OREO                             | (136)                                     |   | (1,386)                                   |
| Gains and fees from the sale of loans                                 | (197)                                     |   | (537)                                     |
| Stock-based compensation expense                                      | 132                                       |   | 88                                        |
| Loss on investment securities                                         | 850                                       |   | -                                         |
| Increase in other assets                                              | (655)                                     |   | (3,476)                                   |
| Increase (decrease) in other liabilities                              | (1,645)                                   |   | 3,686                                     |
|                                                                  |                                      |   |                                      |
| Net cash provided by operating activities                             |       4,723 |   |       6,357 |
|                                                                  |                                      |   |                                      |
| INVESTING ACTIVITIES                                                  |                                      |   |                                      |
| Net increase in loans                                                 | (76,892)                                  |   | (42,550)                                  |
| Proceeds from the sale of loans                                       | 12,038                                    |   | 17,762                                    |
| Proceeds from sales of investment securities available-for-sale       | 21,414                                    |   | 4,583                                     |
| Proceeds from maturities of investment securities available-for-sale  | 11,877                                    |   | 12,619                                    |
| Proceeds from maturities of investment securities held-to-maturity    | -                                         |   | 5                                         |
| Purchases of investment securities available-for-sale                 | (42,557)                                  |   | (21,840)                                  |
| Purchase of Bank Owned Life Insurance                            | (10,000)                                  |   | -                                         |
| Purchase of premises and equipment                                    | (3,752)                                   |   | (6,180)                                   |
| Proceeds from the sale of fixed assets                                | 119                                       |   | 89                                        |
|                                                                  |                                      |   |                                      |
| Net cash used in investing activities                                 |   (87,753)                      |   |   (35,512)                      |
|                                                                  |                                      |   |                                      |
| FINANCING ACTIVITIES                                                  |                                      |   |                                      |
| Decrease in short term Federal Home Loan Bank                         |                                      |   |                                      |
| and other short term borrowings                                       | -                                         |   | (5,266)                                   |
| Increase in long term Federal Home Loan Bank borrowings               | 111,500                                   |   | 35,000                                    |
| Repayment of long term Federal Home Loan Bank borrowings              | (78,300)                                  |   | (5,930)                                   |
| Net increase in deposits                                              | 56,621                                    |   | 18,553                                    |
| Cash dividends paid                                                   | (2,179)                                   |   | (2,088)                                   |
| Proceeds from issuance of guaranteed preferred beneficial interest in |                                      |   |                                      |
| Corporations subordinated debentures                                  | -                                         |   | 5,155                                     |
| Repayment of guaranteed preferred beneficial interest in              |                                      |   |                                      |
| Corporations subordinated debentures                                  | -                                         |   | (5,155)                                   |
| Net increase (decrease) in treasury stock transactions                | 26                                        |   | (594)                                     |
|                                                                  |                                      |   |                                      |
| Net cash provided by financing activities                             | 87,668                                    |   | 39,675                                    |
|                                                                  |                                      |   |                                      |
| NET INCREASE IN CASH AND CASH EQUIVALENTS                        | 4,638                                     |   | 10,520                                    |
|                                                                  |                                      |   |                                      |
| Cash and cash equivalents at beginning of period                      | 53,360                                    |   | 72,341                                    |
| Cash and cash equivalents at end of period                            | $  57,998                       |   | $   82,861                 |

 

The accompanying notes are an integral part of these statements.

 

5

 

 

----

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY**

**(UNAUDITED)**

 

 

|                        |      |         |          |          | Accumulated    |           |                |          |
|-----------------------------|-----------|--------------|---------------|---------------|----------------|----------------|---------------------|---------------|
|                        |      |         | Additional    |          | Other          |           | Total               |          |
|                        | Common    | Stock        | Paid-in       | Retained      | Comprehensive  | Treasury       | Stockholders’ | Comprehensive |
| (Dollars in thousands)      | Shares    | Par Value    | Capital       | Earnings      | Loss           | Stock          | Equity              | Income        |
|                        |      |         |          |          |           |           |                |          |
| Balance January 1, 2007     | 5,279,815 | $ 5,280 | $ 11,939 | $ 50,486 | $ (1,473) | $ (2,970) | $ 63,262       |          |
|                        |      |         |          |          |           |           |                |          |
| Net income                  | -         | -            | -             | 5,932         | -              | -              | 5,932               | $ 5,932  |
| Cash dividends declared     | -         | -            | -             | (2,088)       | -              | -              | (2,088)             |          |
| Other comprehensive loss    |      |         |          |          |           |           |                |          |
| Net unrealized losses       |      |         |          |          |           |           |                |          |
| on investment securities    |      |         |          |          |           |           |                |          |
| available-for-sale          | -         | -            | -             | -             | (368)          | -              | (368)               | (368)         |
| Treasury stock transactions | -         | -            | (949)         | -             | -              | 443            | (506)               | -             |
| Total comprehensive income  |      |         |          |          |           |           |                | $ 5,564  |
|                        |      |         |          |          |           |           |                |          |
| Balance September 30, 2007  | 5,279,815 | $ 5,280 | $ 10,990 | $54,330       | $ (1,841) | $ (2,527) | $ 66,232       |          |
|                        |      |         |          |          |           |           |                |          |
|                        |      |         |          |          |           |           |                |          |
| Balance January 1, 2008     | 5,279,815 | $ 5,280 | $ 11,113 | $ 55,347 | $ (1,207) | $ (2,554) | $ 67,979       |          |
|                        |      |         |          |          |           |           |                |          |
| Net income                  | -         | -            | -             | 4,169         | -              | -              | 4,169               | $ 4,169  |
| Cash dividends declared     | -         | -            | -             | (2,179)       | -              | -              | (2,179)             |          |
| Other comprehensive loss    |      |         |          |          |           |           |                |          |
| Net unrealized losses       |      |         |          |          |           |           |                |          |
| on investment securities    |      |         |          |          |           |           |                |          |
| available-for-sale          | -         | -            | -             | -             | (2,775)        | -              | (2,775)             | (2,775)       |
| Treasury stock transactions | -         | -            | (587)         | -             | -              | 746            | 159                 | -             |
| Total comprehensive income  |      |         |          |          |           |           |                | $ 1,394  |
|                        |      |         |          |          |           |           |                |          |
| Balance September 30, 2008  | 5,279,815 | $ 5,280 | $ 10,526 | $ 57,337 | $ (3,982) | $ (1,808) | $ 67,353       |          |

 

The accompanying notes are an integral part of these statements.

 

6

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

| **1.** | **BASIS OF PRESENTATION** |
|--------|---------------------------|

 

The foregoing unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America for interim financial information. In the opinion of Management, all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial position and the results of        operations for the interim period presented have been included. Operating results for the nine months ended September 30, 2008 include a $417 thousand reduction of salary and benefits expense associated with loan origination costs not previously deferred in prior periods. Management has concluded that the impact of deferring this expense in the second quarter of 2008 is not material to the Corporation’s consolidated financial statements. These interim financial statements should        be read in conjunction with the consolidated financial statements and footnotes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2007 (our “2007 Annual Report”).

 

The results of operations for the three and nine month periods ended September 30, 2008 are not necessarily indicative of the results to be expected for the full year. Information regarding risks and uncertainties that could cause actual results to vary materially from our prior performance may be found in Part I, Item 1A of our 2007 Annual Report, as supplemented and updated by        disclosures contained in Part II, Item 1A of our Quarterly Report on Form 10-Q for the period ending September 30, 2008.

 

| **2.** | **PROPOSED ACQUISITION** |
|--------|--------------------------|

 

On September 18, 2008, First Chester County Corporation (the “Corporation”), First National Bank of Chester County (the “Bank”) and American Home Bank, National Association (“AHB”) entered into an Agreement and Plan of Merger (the “Merger Agreement”) pursuant to which all of the outstanding shares of AHB will be exchanged for and        converted to cash and shares of the Corporation, and AHB will be merged with and into the Bank, a wholly-owned subsidiary of the Corporation.

 

Under the terms of the Merger Agreement, AHB shareholders may elect to receive either 0.70 shares of common stock of the Corporation or cash equal to $11.00 per share of AHB common stock, in each case, subject to adjustment in certain events. Shareholder elections are subject to allocation procedures, which are intended to ensure that approximately 90% of the consideration to be paid        by the Corporation will be in the form of common stock and approximately 10% of the consideration will be in cash. The total value of the merger consideration is approximately $18.2 million based on the Corporation’s closing price of $15.25 per share on September 18, 2008.

 

AHB is a national bank with assets of approximately $268 million as of June 30, 2008, offering consumer and commercial banking services through two branch offices in Mountville and Carlisle in central Pennsylvania, and has a significant mortgage banking operation. During the twelve months ended August 31, 2008, AHB originated approximately $1 billion in residential mortgage to        qualified borrowers with good credit histories and complete documentation. Such residential mortgage loans are generally conventional conforming, jumbo, FHA and VA loans, as well as construction to permanent loans for homeowners. Both the Bank and AHB avoid funding sub-prime mortgages. Following the merger, the consumer and commercial banking services of AHB and its branch offices will be merged into the banking operations of the Bank, and the AHB mortgage banking operations will be run        as a separate division of the Bank under the American Home Bank name.

 

The transaction, which is expected to close in the fourth quarter of 2008, is subject to shareholder approval by AHB shareholders,  regulatory approvals and other conditions as provided in the Merger Agreement. The Corporation has filed a Registration Statement on Form S-4 with the SEC in connection with this transaction to register the shares of common stock that will be        issued at closing.This Registration Statement was declared effective on October 31, 2008.No assurance can be given that all required approvals will be obtained, that all other closing conditions will be satisfied or waived, or that the transaction will in fact be consummated.

 

 

 

7

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued**

 

| **3.** | **ACCOUNTING FOR STOCK-BASED COMPENSATION PLANS** |
|--------|---------------------------------------------------|

 

At September 30, 2008, the Corporation currently has one unexpired stock based compensation plan, pursuant to which, shares of the Corporation’s common stock could be issued, subject to certain restrictions. The plan, adopted in 2005, allows the Corporation to grant up to 150 thousand shares of restricted stock to employees. During the nine months ended September 30, 2008, the        Corporation granted 34,500 shares valued at $17.80 per share at the grant date. These shares, or a portion thereof, will vest on the third anniversary of the grant date subject to certain employment and company performance requirements. During the nine months ended September 30, 2007, the Corporation granted 22,900 shares valued at $21.05 per share at the grant date. One third of these shares vest on each of the first three anniversaries of the date of the grant. These restricted stock        grants are also subject to accelerated vesting of all or a portion of the shares upon the occurrence of certain events, as described more fully in our proxy statement. A summary of the Corporation’s unvested restricted shares is as follows:

 

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

 

|                           | Shares       | Grant Date Fair

Value | Aggregate Intrinsic Value

of Unvested Shares |
|--------------------------------|--------------|------------------------|-----------------------------------------------|
| Unvested at January 1, 2008    | 21,400       | $21.05                 | -                                             |
| Granted                        | 34,500       | $17.80                 | -                                             |
| Vested                         |   7,138 | $21.05                 | -                                             |
| Forfeited                      |   1,441 | $18.85                 | -                                             |
| Unvested at September 30, 2008 | 48,762       | $18.78                 | $666.3                                        |

 

The Corporation recorded $132 thousand and $88 thousand of restricted stock expense for the nine months ended September 30, 2008 and 2007, respectively.

 

The Coporation also has one expired Stock Option Plan. Although the Corporation’s ability to issue stock options under the 1995 Stock Option Plan has expired, outstanding stock options remain in effect according to their terms. Aggregated information regarding the Corporation’s Stock Option Plan as of September 30, 2008 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, 2008    | 208,308                        | $15.00                             | -                                                      | $496                                |
| Granted                           | -                              | -                                  | -                                                      | -                                   |
| Exercised                         | -                              | -                                  | -                                                      | -                                   |
| Forfeited                         | (50,454)                       | 16.65                              | -                                                      | -                                   |
| Expired                           | -                              | -                                  | -                                                      | -                                   |
| Outstanding at September 30, 2008 | 157,854                        | $14.47                             | 2.46                                                   | $96                                 |
| Exercisable at September 30, 2008 | 157,854                        | $14.47                             | 2.46                                                   | $96                                 |

 

There were no options granted during the nine months ended September 30, 2008. The total intrinsic value (market value on date of exercise less grant price) of options exercisable at September 30, 2008 is $96 thousand. As of January 1, 2007, there were no unvested options under the Corporation’s one stock option plan.

 

 

 

 

 

 

 

8

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued**

 

| **4.** | **EARNINGS PER SHARE** |
|--------|------------------------|

 

**Three Months ended September 30, 2008**

 

|                                        | Income      |   |          |   |        |
|---------------------------------------------|-------------|--------|---------------|--------|-------------|
|                                        | (thousands) |   | Shares        |   | Per Share   |
|                                        | (numerator) |   | (denominator) |   | Amount      |
| Basic earnings per share                    |        |   |          |   |        |
| Net income available to common stockholders | $ 807  |   | 5,188,562     |   | $ 0.16 |
| Effect of Dilutive Securities               |        |   |          |   |        |
| Options to purchase common stock            | -           |   | 9,225         |   | -           |
| Diluted earnings per share                  |        |   |          |   |        |
| Net income available to common stockholders | $ 807  |   | 5,197,787     |   | $ 0.16 |

 

58,768 anti-dilutive weighted shares have been excluded from this computation because the option exercise price was greater than the average market price of the common shares.

 

**Nine Months ended September 30, 2008**

 

|                                        | Income       |   |          |   |        |
|---------------------------------------------|--------------|--------|---------------|--------|-------------|
|                                        | (thousands)  |   | Shares        |   | Per Share   |
|                                        | (numerator)  |   | (denominator) |   | Amount      |
| Basic earnings per share                    |         |   |          |   |        |
| Net income available to common stockholders | $ 4,169 |   | 5,184,173     |   | $ 0.80 |
| Effect of Dilutive Securities               |         |   |          |   |        |
| Options to purchase common stock            | -            |   | 16,027        |   | -           |
| Diluted earnings per share                  |         |   |          |   |        |
| Net income available to common stockholders | $ 4,169 |   | 5,200,200     |   | $ 0.80 |

 

62,665 anti-dilutive weighted shares have been excluded from this computation because the option exercise price was greater than the average market price of the common shares.

 

**Three Months ended September 30, 2007**

 

|                                        | Income       |   |          |   |        |
|---------------------------------------------|--------------|--------|---------------|--------|-------------|
|                                        | (thousands)  |   | Shares        |   | Per Share   |
|                                        | (numerator)  |   | (denominator) |   | Amount      |
| Basic earnings per share                    |         |   |          |   |        |
| Net income available to common stockholders | $ 2,777 |   | 5,165,735     |   | $ 0.54 |
| Effect of Dilutive Securities               |         |   |          |   |        |
| Options to purchase common stock            | -            |   | 55,432        |   | (.01)       |
| Diluted earnings per share                  |         |   |          |   |        |
| Net income available to common stockholders | $ 2,777 |   | 5,221,167     |   | $ 0.53 |

 

11,987 anti-dilutive weighted shares have been excluded from this computation because the option exercise price was greater than the average market price of the common shares.

 

**Nine Months ended September 30, 2007**

 

|                                        | Income       |   |          |   |        |
|---------------------------------------------|--------------|--------|---------------|--------|-------------|
|                                        | (thousands)  |   | Shares        |   | Per Share   |
|                                        | (numerator)  |   | (denominator) |   | Amount      |
| Basic earnings per share                    |         |   |          |   |        |
| Net income available to common stockholders | $ 5,932 |   | 5,159,868     |   | $ 1.15 |
| Effect of Dilutive Securities               |         |   |          |   |        |
| Options to purchase common stock            | -            |   | 62,091        |   | (.01)       |
| Diluted earnings per share                  |         |   |          |   |        |
| Net income available to common stockholders | $ 5,932 |   | 5,221,959     |   | $ 1.14 |

 

13,105 anti-dilutive weighted shares have been excluded from this computation because the option exercise price was greater than the average market price of the common shares.

 

9

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued**

 

| **5.** | **COMPREHENSIVE INCOME** |
|--------|--------------------------|

 

Components of comprehensive income are presented in the following chart:

 

|   | **Three Months Ended** | **Nine Months Ended** |
|--------|------------------------|-----------------------|

|   | **September 30,** | **September 30,** |
|--------|-------------------|-------------------|

 

|                                        | **2008**      |   | **2007**      |   | **2008**      |   | **2007** |
|---------------------------------------------|---------------|--------|---------------|--------|---------------|--------|----------|
| Unrealized gains (losses) on securities:    |          |   |          |   |          |   |     |
| Unrealized gains (losses) arising in period | $ (1,519)     |   | $ 956         |   | $ (3,627)     |   | $ (560)  |
| Reclassification adjustment                 | (761)         |   | -             |   | (577)         |   | 2        |
| Net unrealized gain (loss)                  | (2,280)       |   | 956           |   | (4,204)       |   | (558)    |
| Other comprehensive income before taxes     | (2,280)       |   | 956           |   | (4,204)       |   | (558)    |
| Income tax benefit (expense)                | 775           |   | (325)         |   | 1,429         |   | 190      |
| Other comprehensive income (loss)           | (1,505)       |   | 631           |   | (2,775)       |   | (368)    |
| Net income                                  | 807           |   | 2,777         |   | 4,169         |   | 5,932    |
| Total comprehensive income (loss)           | $  (698) |   | $  3,408 |   | $  1,394 |   | $ 5,564  |

 

 

| **6.** | **RECENT ACCOUNTING PRONOUNCEMENTS** |
|--------|--------------------------------------|

 

In October 2008, the FASB issued FSP FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset is Not Active,” (“FSP FAS 157-3”). FSP FAS 157-3 clarifies the application of SFAS 157 in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when        the market for that financial asset is not active. We adopted the provisions of FSP FAS 157-3 in September 2008. FSP FAS 157-3 did not have a material impact on our consolidated financial statements.

In June 2008, the FASB posted FASB Staff Position No. EITF 03-6-1,“Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities,” (“FSP EITF 03-6-1”). This statement addressed whether instruments granted in share-based payment transactions are participating securities prior to vesting and, therefore, need to be        included in the calculation of earnings per share (EPS) as described in FASB Statement No. 128,*Earnings per Share.*The FSP is effective for financial statements issued for fiscal years beginning after December 15, 2008 with prior period EPS data adjusted retrospectively to conform to its provisions. The Corporation has not yet determined the impact, if any, that FSP EITF 03-6-1 will have on our consolidated financial        statements.

In May 2008, the FASB issued Statement of Financial Accounting Standards No. 162,“The Hierarchy of Generally Accepted Accounting Principles,” (“SFAS No. 162”). This statement identifies the sources of accounting principles and the framework for selecting the principles to be used in the preparation of financial statements presented in conformity with generally        accepted accounting principles (GAAP) in the United States.

In February 2008, the FASB issued Staff Position 157-2 (“FSP 157-2”), “Effective Date of FASB Statement No. 157.”  This FSP delays the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value on a recurring basis (at least annually) to fiscal years beginning after        November 15, 2008, and interim periods within those fiscal years. FSP 157-2 did not have a material impact on our consolidated financial statements.

In December 2007, the SEC released Staff Accounting Bulletin SAB 110 (“SAB 110”), “Share Based Payment.” SAB 110 expresses the views of the SEC staff regarding the use of a simplified method, as discussed in SAB 107, in developing an estimate of the expected term of share options in accordance with SFAS 123R. This interpretation gives specific examples of when it        may be appropriate to use the simplified method of determining the expected term. SAB 110 is effective for fiscal years beginning on or after January 1, 2008. We adopted the provisions of SAB 110 on January 1, 2008. SAB 110 did not have a material impact on our consolidated financial statements.

 

 

10

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued**

 

In December 2007, the FASB issued Statement No. 141(R) (“SFAS 141(R)”), “Business Combinations.” This Statement replaces SFAS 141, “Business Combinations.” This Statement retains the fundamental requirements in Statement 141 that the acquisition method of accounting (which Statement 141 called the “purchase method”) be used for all        business combinations and for an acquirer to be identified for each business combination. This Statement also establishes principles and requirements for how the acquirer: a) recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree; b) recognizes and measures the goodwill acquired in the business combination or a gain from a bargain purchase and c) determines what information to        disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141(R) will apply prospectively to business combinations for which the acquisition date is on or after the first annual reporting period beginning on or after December 15, 2008. While the Corporation has not yet evaluated SFAS 141(R) for the impact, if any, that SFAS 141(R) will have on our consolidated financial statements, we will be required to expense        costs related to any acquisitions on or after January 1, 2009, rather than capitalize such costs as currently required.

 

In December 2007, the FASB issued Statement No. 160 (“SFAS 160”), “Noncontrolling Interests in Consolidated Financial Statements.” This Statement amends Accounting Research Bulletin 51 to establish accounting and reporting standards for the noncontrolling (minority) interest in a subsidiary and for the deconsolidation of a subsidiary. It clarifies that a        noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. SFAS 160 is effective for fiscal years beginning on or after December 15, 2008. The Corporation has not yet determined the impact, if any, that SFAS 160 will have on our consolidated financial statements.

 

In November 2007, the SEC released Staff Accounting Bulletin SAB 109 (“SAB 109”), “Written Loan Commitments Recorded at Fair Value Through Earnings.” This bulletin expresses the views of the SEC staff regarding written loan commitments that are accounted for at fair value through earnings under GAAP. SAB 109 is effective for fiscal years beginning after        December 31, 2007. We adopted the provisions of SAB 109 on January 1, 2008. SAB 109 did not have a material impact on our consolidated financial statements.

 

In March 2007, the FASB ratified Emerging Issues Task Force, or EITF, Issue 06-11, “Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards.” EITF 06-11 requires companies to recognize the income tax benefit realized from dividends or dividend equivalents that are charged to retained earnings and paid to employees for nonvested equity-classified        employee share-based payment awards as an increase to additional paid-in capital. EITF 06-11 is effective for fiscal years beginning after September 15, 2007 (our fiscal year beginning January 1, 2008). We adopted the provisions of EITF 06-11 on January 1, 2008. EITF 06-11 did not have a material impact on our consolidated financial statements.

 

In February 2007, the FASB issued Statement No. 159 (“SFAS 159”), “The Fair Value Option for Financial Assets and Financial Liabilities - Including an Amendment of FASB Statement No. 115.” This statement permits entities to choose to measure many financial instruments and certain other items at fair value at specified election dates. The statement defines items        eligible for the measurement option. A business entity shall report in earnings unrealized gains and losses on items for which the fair value option has been elected at each subsequent reporting date. We adopted the provisions of SFAS No. 159 on January 1, 2008. SFAS 159 did not have a material impact on our consolidated financial statements.

 

In September 2006, the FASB issued Statement No. 157 (“SFAS 157”), “Fair Value Measurements.”  This statement clarifies the principle that fair value should be based on the assumptions that market participants would use when pricing an asset or liability. Additionally, it establishes a fair value hierarchy that prioritizes the information used to        develop those assumptions. The provisions of SFAS No. 157 are effective as of the beginning of our 2008 fiscal year.  We adopted the provisions of SFAS No. 157 on January 1, 2008. SFAS 157 did not have a material impact on our consolidated financial statements.

 

 

 

 

11

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued**

 

| **7.** | **FAIR MARKET VALUE** |
|--------|-----------------------|

 

Statement 157 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants on the measurement date. Statement 157 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when        measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

 

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

 

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

 

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

 

The Corporation used the following methods and significant assumptions to estimate fair value.

 

Securities: Trading securities and investment securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying        exclusively on quoted prices for the specific securities but rather by relaying on the securities’ relationship to other benchmark quoted securities. Level 1 securities include those traded on nationally recognized securities exchanges, U.S. Treasury and Agency securities, and money market funds. Level 2 securities include mortgage-backed securities issued by government sponsored entities, municipal bonds and corporate debt securities. Securities classified as Level 3 include        asset-backed securities in less liquid markets.

 

Loans held for sale: The fair value of loans held for sale is determined, when possible, using quoted secondary-market prices. If no such quoted price exists, the fair value of a loan is determined using quoted prices for a similar asset or assets, adjusted for the specific attributes of that loan. As such, the Corporation classifies loans subjected to nonrecurring fair value        adjustments as Level 2.

 

Loans: The Corporation does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and an allowance for loan losses is established. Loans for which it is probable that payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is        identified as individually impaired, management measures impairment in accordance with SFAS 114, “Accounting by Creditors for Impairment of a Loan,” ("SFAS 114"). The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or        collateral exceed the recorded investments in such loans. At September 30, 2008, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with SFAS 157, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or a current appraised value, the Corporation records the        impaired loan as nonrecurring Level 3. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Corporation records the impaired loan as nonrecurring Level 3.

 

Foreclosed assets: Foreclosed assets are adjusted to fair value upon transfer of the loans to foreclosed assets. Subsequently, foreclosed assets are carried at the lower of carrying value or fair value. Fair value is based upon independent market prices, appraised values of the collateral or management’s estimation of the value of the collateral. When the fair value of the        collateral is based on an observable market price or a current appraised value, the Corporation records the foreclosed asset as nonrecurring Level 2. When an appraised value is not available or management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Corporation records the foreclosed asset as nonrecurring Level 3.

 

12

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – Continued**

 

The table below presents the balance of assets and liabilities at September 30, 2008 measured at fair value on a recurring

basis:

 

| *Dollars in thousands*                   |   |    |   |    |   |    |   |                         |
|------------------------------------------|--------|---------|--------|---------|--------|---------|--------|-------------------------|
|                                     |   | Level 1 |   | Level 2 |   | Level 3 |   | September 30, 2008Total |
| Investment securities available for sale |   | $2,679  |   | $99,533 |   | $ -     |   | $102,212                |

 

 

The table below presents the balance of assets and liabilities at September 30, 2008 measured at fair value on a nonrecurring basis:

 

| *Dollars in thousands* |   |    |   |    |   |    |   |                          |
|------------------------|--------|---------|--------|---------|--------|---------|--------|--------------------------|
|                   |   | Level 1 |   | Level 2 |   | Level 3 |   | September 30, 2008 Total |
| Loans                  |   | $ -     |   | $ -     |   | $3,642  |   | $3,642                   |
| OREO                   |   | $ -     |   | $ -     |   | $346    |   | $346                     |

 

 

| **8.** | **ASSET IMPAIRMENT** |
|--------|----------------------|

 

In the third quarter of 2008, the Corporation recorded an $850 thousand pre-tax other than temporary impairment loss on a $1 million Lehman Brothers Note held in the Bank’s investment portfolio. The loss is presented on the “Asset impairment line” of the Corporation’s Consolidated Statement of Income. The remaining $150 thousand is presented on the        “Investment securities available for sale” line of the Corporation’s Consolidated Balance Sheet.

 

In the third quarter of 2008 the Corporation recorded a $417 thousand pretax loss on a $13.9 million overnight investment in the Reserve Primary Fund. The Reserve Primary Fund is a short term overnight money market fund designed to maintain a constant $1.00 per share value. The Bank typically uses this type of fund to invest excess overnight cash. During the third quarter of 2008, the        fund’s value fell below $1.00 per share due to underlying Lehman Brothers commercial paper in the fund. The fund is currently in process of liquidation. The Bank wrote its $13.9 million investment down to $13.5 million. The Bank expects to fully recover the remaining $13.5 million. The remaining $13.5 million is presented on the “Federal funds sold and other overnight investments” line of the Corporation’s Consolidated Balance Sheet. The $417 thousand loss is        presented on the “Asset impairment” line of the Corporation’s Consolidated Statement of Income.

 

| **9.** | **RECLASSIFICATIONS** |
|--------|-----------------------|

 

Certain 2007 numbers have been reclassified to conform with current period presentation. These reclassifications have no impact on net income or earnings per share.

 

13

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

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

 

This discussion is intended to further your understanding of the consolidated financial condition and results of operations of First Chester County Corporation and its direct and indirect wholly-owned subsidiaries, First National Bank of Chester County (the “Bank”), FNB Property Management, LLC, First National Insurance Services, LLC, Turks Head        Properties, Inc., Turks Head II, LLC, First Chester County Capital Trust I, First Chester County Capital Trust II, and First Chester County Capital Trust III, (collectively, the “Corporation”). This discussion should be read in conjunction with the consolidated financial statements included in this report.

 

In addition to historical information, this discussion and analysis contains statements relating to future results of the Corporation that are considered “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements can often be identified by the use of forward-looking terminology such as        “believes,” “expects,” “intends,” “may,” “will,” “should,” “or anticipates” or similar terminology. These statements involve risks and uncertainties and are based on various assumptions. Although the Corporation believes that its expectations are based on reasonable assumptions, investors and prospective investors are cautioned that such statements are only projections, and that these risks and        uncertainties are all difficult to predict and most are beyond the control of the Corporation’s Management. Information about the primary risks and uncertainties that could cause the Corporation’s actual future results to differ materially from our historic results or the results described in forward-looking statements made in this report or presented elsewhere by Management from time to time are included in Part I, Item 1A of our 2007 Annual Report, as supplemented and        updated by disclosures contained in Part II, Item 1A of this Report.

 

The Corporation undertakes no obligation to publicly release any revisions to any forward-looking statements to reflect events or circumstances after the date of this Report.

 

**CRITICAL ACCOUNTING POLICIES, JUDGMENTS AND ESTIMATES**

 

The accounting and reporting policies of the Corporation conform with the accounting principles generally accepted in the United States of America and general practices within the financial services industry. The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that        affect the amounts reported in the financial statements and the accompanying notes. Actual results could differ from those estimates.

 

**ALLOWANCE FOR LOAN AND LEASE LOSSES**

 

The Corporation considers that the determination of the allowance for loan and lease losses involves a higher degree of judgment and complexity than its other significant accounting policies. The balance in the allowance for loan losses is determined based on Management’s review and evaluation of the loan and lease portfolio in relation to past loss experience, the size and composition of the        portfolio, current economic events and conditions, and other pertinent factors, including Management’s assumptions as to future delinquencies, recoveries and losses. All of these factors may be susceptible to significant change. To the extent actual outcomes differ from Management’s estimates, additional provisions for loan and lease losses may be required that would adversely impact earnings in future periods.

 

 

14

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

**INCOME TAXES**

 

Under the liability method, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities. Deferred tax assets are subject to Management’s judgment based upon available evidence that future realization is more likely than not. If Management determines that the Corporation may be unable to realize all or part of the        net deferred tax assets in the future, a direct charge to income tax expense may be required to reduce the recorded value of the net deferred tax asset to the expected realizable amount.

 

**EARNINGS AND DIVIDEND SUMMARY**

 

Net income for the three months ended September 30, 2008 was $807 thousand, a decrease of $1.97 million or 70.9% from $2.78 million for the same period in 2007. Net income for the nine month period ended September 30, 2008 was $4.17 million, a decrease of $1.76 million or 29.7% from $5.93 million for the same period in 2007. Diluted earnings per share for the three and nine month periods ended September        30, 2008 were $0.16 and $0.80, respectively, compared to $0.53 and $1.14 for the same periods in 2007. Cash dividends declared for the three and nine month periods ended September 30, 2008 were $0.140 and $0.420 per share compared to $0.135 and $0.4050 per share for the three and nine month periods ended September 30, 2007.

 

The results for the three and nine months ended September 30, 2008 were negatively impacted by certain events. In the third quarter of 2008, the Corporation recorded a $1.44 million pretax loss from the write-down of assets, including an $850 thousand non-cash pretax other than temporary impairment loss on a $1 million Lehman Brothers Note held in the Bank’s investment portfolio, a $417 thousand        pretax loss on a $13.9 million investment in the Reserve Primary Fund, a short term overnight money market fund, and a $169 thousand non-cash pretax write-down of property held as OREO. The aggregate after tax impact of these losses in the third quarter of 2008 is $948 thousand. The impairment write-down of the Lehman Note and the loss on the Reserve Primary Fund are presented on the “Asset impairment” line of the income statement while the write-down of OREO is presented on        the “gains (losses) on fixed assets and OREO” line of the income statement. In addition, during the second quarter of 2008, the Corporation deferred certain loan origination costs that should have been deferred previously under SFAS 91. This resulted in a $417 thousand pretax reduction of salary and employee benefits expense in the second quarter of 2008.

 

The Reserve Primary Fund mentioned above, is a short term overnight money market fund designed to maintain a constant $1.00 per share value. We typically use this type of fund to invest excess overnight cash and categorize this on the balance sheet as Federal funds sold and other overnight investments. During the third quarter of 2008, the fund’s value fell below $1.00 per share due to underlying        Lehman Brothers commercial paper in the fund. Currently, the fund is in process of liquidation. The Bank wrote its $13.9 million investment down to $13.5 million. The Bank expects to fully recover the remaining $13.5 million.

 

The 2007 results include a $1.39 million gain on the sale of facilities in the third quarter of 2007 and $507 thousand of pretax gains and interest income recorded in the second quarter of 2007 from the sale of a $5.9 million loan that had been on non-accrual status. The after tax impact of these 2007 events is a $1.2 million gain.

 

 

15

 

 

----

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

| **SELECTED RATIOS** | **Three Months Ended** | **Nine Months Ended** |
|---------------------|------------------------|-----------------------|

|   | **September 30,** | **September 30,** |
|--------|-------------------|-------------------|

 

|                     | **2008** |   | **2007** |   | **2008** |   | **2007** |
|--------------------------|----------|--------|----------|--------|----------|--------|----------|
| Return on Average Assets | 0.32%    |   | 1.23%    |   | 0.57%    |   | 0.89%    |
| Return on Average Equity | 4.65%    |   | 17.18%   |   | 8.03%    |   | 12.38%   |
| Dividend Payout Ratio    | 89.96%   |   | 25.08%   |   | 52.27%   |   | 35.20%   |
| Book Value Per Share     | $12.98   |   | $12.83   |   | $12.98   |   | $12.83   |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

16

 

 

----

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

**CONSOLIDATED AVERAGE BALANCE SHEET**

**AND TAXABLE EQUIVALENT INCOME/EXPENSE AND RATES FOR THE**

**THREE MONTHS ENDED SEPTEMBER 30,**

 

|   | 2008 | 2007 |
|--------|------|------|

 

| (Dollars in thousands)                                                                                  |     |     |   |   |     |     |   |
|---------------------------------------------------------------------------------------------------------|----------|----------|--------|--------|----------|----------|--------|
|                                                                                                    | Average  |     |   |   | Average  |     |   |
|                                                                                                    | Balance  | Interest | Rate%  |   | Balance  | Interest | Rate%  |
| ASSETS                                                                                                  |     |     |   |   |     |     |   |
| Federal funds sold, interest-bearing

deposits in banks and other

overnight investments | $32,732  | $200     | 2.43%  |   | $50,956  | $676     | 5.26%  |
| Investment securities:                                                                             |     |     |   |   |     |     |   |
| Taxable                                                                                                 | 95,261   | 1,157    | 4.83%  |   | 76,866   | 940      | 4.85%  |
| Tax-exempt (1)                                                                                     | 12,180   | 142      | 4.63%  |   | 13,540   | 157      | 4.60%  |
| Total investment securities                                                                   | 107,441  | 1,299    | 4.81%  |   | 90,406   | 1,097    | 4.82%  |
|                                                                                                    |     |     |   |   |     |     |   |
| Loans and leases: (2)                                                                    |     |     |   |   |     |     |   |
| Taxable                                                                                                 | 780,095  | 12,190   | 6.22%  |   | 700,936  | 12,479   | 7.06%  |
| Tax-exempt (1)                                                                                     | 18,477   | 340      | 7.33%  |   | 15,307   | 256      | 6.62%  |
| Total loans and leases                                                                   | 798,572  | 12,530   | 6.24%  |   | 716,243  | 12,735   | 7.05%  |
|                                                                                                    |     |     |   |   |     |     |   |
| Total interest-earning assets                                                                 | 938,745  | 14,029   | 5.95%  |   | 857,605  | 14,508   | 6.71%  |
| Non-interest-earning assets                                                                        |     |     |   |   |     |     |   |
| Allowance for loan and lease losses                                                      | (8,507)  |     |   |   | (8,053)  |     |   |
| Cash and due from banks                                                             | 22,003   |     |   |   | 26,736   |     |   |
| Other assets                                                                                       | 41,572   |     |   |   | 29,895   |     |   |
|                                                                                                    |     |     |   |   |     |     |   |
| Total assets                                                                                       | $993,813 |     |   |   | $906,183 |     |   |
|                                                                                                    |     |     |   |   |     |     |   |
| LIABILITIES AND STOCKHOLDERS’                                                                     |     |     |   |   |     |     |   |
| EQUITY                                                                                                  |     |     |   |   |     |     |   |
| Savings, NOW, and money market                                                      |     |     |   |   |     |     |   |
| deposits                                                                                                | $405,983 | $1,646   | 1.61%  |   | $380,324 | $2,462   | 2.57%  |
| Certificates of deposit and other time                                         | 222,231  | 2,001    | 3.58%  |   | 241,300  | 2,876    | 4.73%  |
| Total interest-bearing deposits                                                               | 628,214  | 3,647    | 2.31%  |   | 621,624  | 5,338    | 3.41%  |
| Subordinated debentures                                                                            | 15,465   | 209      | 5.38%  |   | 15,913   | 321      | 8.00%  |
| Federal Home Loan Bank advances                                                     |     |     |   |   |     |     |   |
| and other borrowings                                                                          | 151,521  | 1,470    | 3.86%  |   | 74,094   | 731      | 3.92%  |
| Total interest-bearing liabilities                                                            | 795,200  | 5,326    | 2.66%  |   | 711,631  | 6,390    | 3.56%  |
| Non-interest-bearing liabilities:                                                                  |     |     |   |   |     |     |   |
| Non-interest-bearing demand deposits                                                          | 119,885  |     |   |   | 122,174  |     |   |
| Other liabilities                                                                                  | 9,325    |     |   |   | 7,702    |     |   |
| Total liabilities                                                                                  | 924,410  |     |   |   | 841,507  |     |   |
| Stockholders’ equity                                                                         | 69,403   |     |   |   | 64,676   |     |   |
| Total liabilities and stockholders’ equity                                    | $993,813 |     |   |   | $906,183 |     |   |
|                                                                                                    |     |     |   |   |     |     |   |
| Net interest income                                                                           |     | $8,703   |   |   |     | $8,118   |   |
| Net yield on interest-earning assets                                                |     |     | 3.69%  |   |     |     | 3.76%  |

 

|   | (1) | The indicated income and annual rate are presented on a taxable equivalent basis using the federal marginal rate of 34% |
|--------|-----|-------------------------------------------------------------------------------------------------------------------------|

adjusted for the TEFRA Act 20% interest expense disallowance for 2008 and 2007.

|   | (2) | Non-accruing loans are included in the average balance. |
|--------|-----|---------------------------------------------------------|

 

 

17

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

**CONSOLIDATED AVERAGE BALANCE SHEET**

**AND TAXABLE EQUIVALENT INCOME/EXPENSE AND RATES FOR THE**

**NINE MONTHS ENDED SEPTEMBER 30,**

 

|   | 2008 | 2007 |
|--------|------|------|

 

| (Dollars in thousands)                                                                                  |     |     |   |   |     |      |   |
|---------------------------------------------------------------------------------------------------------|----------|----------|--------|--------|----------|-----------|--------|
|                                                                                                    | Average  |     |   |   | Average  |      |   |
|                                                                                                    | Balance  | Interest | Rate%  |   | Balance  | Interest  | Rate%  |
| ASSETS                                                                                                  |     |     |   |   |     |      |   |
| Federal funds sold, interest-bearing

deposits in banks and other

overnight investments | $45,773  | $1,068   | 3.12%  |   | $48,452  | $1,920    | 5.30%  |
| Investment securities:                                                                             |     |     |   |   |     |      |   |
| Taxable                                                                                                 | 97,234   | 3,515    | 4.83%  |   | 78,855   | 2,836     | 4.81%  |
| Tax-exempt (1)                                                                                     | 13,078   | 463      | 4.73%  |   | 11,336   | 376       | 4.43%  |
| Total investment securities                                                                   | 110,312  | 3,978    | 4.82%  |   | 90,191   | 3,212     | 4.76%  |
|                                                                                                    |     |     |   |   |     |      |   |
| Loans and leases: (2)                                                                    |     |     |   |   |     |      |   |
| Taxable                                                                                                 | 754,518  | 36,143   | 6.40%  |   | 695,654  | 36,703(3) | 7.05%  |
| Tax-exempt (1)                                                                                     | 18,983   | 1,029    | 7.24%  |   | 14,337   | 731       | 6.82%  |
| Total loans and leases                                                                   | 773,501  | 37,172   | 6.42%  |   | 709,991  | 37,434    | 7.05%  |
|                                                                                                    |     |     |   |   |     |      |   |
| Total interest-earning assets                                                                 | 929,586  | 42,218   | 6.07%  |   | 848,634  | 42,566    | 6.71%  |
| Non-interest-earning assets                                                                        |     |     |   |   |     |      |   |
| Allowance for loan and lease losses                                                      | (8,122)  |     |   |   | (8,106)  |      |   |
| Cash and due from banks                                                             | 20,375   |     |   |   | 24,920   |      |   |
| Other assets                                                                                       | 38,797   |     |   |   | 27,679   |      |   |
|                                                                                                    |     |     |   |   |     |      |   |
| Total assets                                                                                       | $980,636 |     |   |   | $893,127 |      |   |
|                                                                                                    |     |     |   |   |     |      |   |
| LIABILITIES AND STOCKHOLDERS’                                                                     |     |     |   |   |     |      |   |
| EQUITY                                                                                                  |     |     |   |   |     |      |   |
| Savings, NOW, and money market                                                      |     |     |   |   |     |      |   |
| deposits                                                                                                | $391,067 | $5,287   | 1.81%  |   | $367,937 | $6,741    | 2.45%  |
| Certificates of deposit and other time                                         | 226,362  | 6,812    | 4.02%  |   | 249,291  | 8,736     | 4.69%  |
| Total interest-bearing deposits                                                               | 617,429  | 12,099   | 2.62%  |   | 617,228  | 15,477    | 3.35%  |
| Subordinated debentures                                                                            | 15,465   | 683      | 5.90%  |   | 15,654   | 1,155(4)  | 9.87%  |
| Federal Home Loan Bank advances                                                     |     |     |   |   |     |      |   |
| and other borrowings                                                                          | 150,129  | 4,390    | 3.91%  |   | 67,363   | 1,950     | 3.87%  |
| Total interest-bearing liabilities                                                            | 783,023  | 17,172   | 2.93%  |   | 700,245  | 18,582    | 3.55%  |
| Non-interest-bearing liabilities:                                                                  |     |     |   |   |     |      |   |
| Non-interest-bearing demand deposits                                                          | 118,776  |     |   |   | 121,632  |      |   |
| Other liabilities                                                                                  | 9,577    |     |   |   | 7,368    |      |   |
| Total liabilities                                                                                  | 911,376  |     |   |   | 829,245  |      |   |
| Stockholders’ equity                                                                         | 69,260   |     |   |   | 63,882   |      |   |
| Total liabilities and stockholders’ equity                                    | $980,636 |     |   |   | $893,127 |      |   |
|                                                                                                    |     |     |   |   |     |      |   |
| Net interest income                                                                           |     | $25,046  |   |   |     | $23,984   |   |
| Net yield on interest-earning assets                                                |     |     | 3.60%  |   |     |      | 3.78%  |

   

     (1) The indicated income and annual rate are presented on a taxable equivalent basis using the federal marginal rate of 34% adjusted for

           the TEFRA Act 20% interest expense disallowance for 2008 and 2007.

|   | (2) | Non-accruing loans are included in the average balance. |
|--------|-----|---------------------------------------------------------|

|   | (3) | Includes $282 thousand of income related to the sale of a $5.9 million loan that had been on non-accrual status. |
|--------|-----|------------------------------------------------------------------------------------------------------------------|

 

18

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

**NET INTEREST INCOME**

 

Net interest income is the difference between interest income earned on interest-earning assets and interest expense paid on interest-bearing liabilities. Net interest income on a tax equivalent basis for the three month period ended September 30, 2008 was $8.7 million, an increase of 7.2% from $8.1 million for the same period in 2007. Net interest income on a tax equivalent basis for the nine month        period ended September 30, 2008 was $25.0 million, an increase of 4.4% from $24.0 million for the same period in 2007.

 

The net yield on interest-earning assets, on a tax-equivalent basis, was 5.95% for the three month period ended September 30, 2008, compared to 6.71% for the same period in 2007, a decrease of 76 basis points (one basis point is equal to 1/100 of a percent). For the nine month period ended September 30, 2008, the net yield on interest earning assets decreased 64 basis points to 6.07% from 6.71% during the        same period in 2007.

 

Average interest-earning assets increased approximately $81.1 million or 9.5% to $938.7 million for the three months ended September 30, 2008 from $857.6 million in the same period last year. Average interest-earning assets increased approximately $81.0 million or 9.5% for the nine months ended September 30, 2008 to $929.6 million from $848.6 million in the same period in 2007.

 

Average interest-bearing liabilities increased approximately $83.6 million or 11.7% to $795.2 million for the three months ended September 30, 2008, from $711.6 million for the same period in 2007. Average interest-bearing liabilities increased approximately $82.8 million or 11.8% to $783.0 million for the nine months ended September 30, 2008, from $700.2 million for the same period in 2007.

 

**INTEREST INCOME**

 

Interest income on Federal Funds sold and other overnight investments for the three and nine month periods ended September 30, 2008, decreased $475 thousand and $852 thousand to $200 thousand and $1.1 million, respectively, when compared to the same periods in 2007. The decrease in interest income on Federal Funds sold and other overnight investments for the three and nine month periods is primarily due        to decreases in the rates earned on these balances as a result of Federal Reserve actions to reduce market interest rates. The rates earned on these balances decreased 283 basis points and 218 basis points for the three and nine months ended September 30, 2008, respectively, as compared to the same periods in 2007. The decrease in interest income on Federal Funds sold and other overnight investments for the three and nine months is also due to a decrease in the average balance of        Federal Funds sold and other overnight investments.

 

On a tax equivalent basis, interest income on investment securities increased 18.4% or $202 thousand to $1.3 million for the three month period ended September 30, 2008 when compared to the same period in 2007. For the nine month period ended September 30, 2008, interest income on investment securities increased 23.8% or $766 thousand to $4.0 million from $3.2 million when compared to the same period in        2007. The increase for the three month period is due to an 18.8% or $17.0 million increase of the average balance of investment securities, combined with a 1 basis point decrease earned on these investments. The increase for the nine month period ended September 30, 2008 is the result of a 22.3% or $20.1 million increase of the average balance of investment securities combined with an increase of 6 basis points on the rate earned on these investments.

 

19

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

Interest income on loans, on a tax equivalent basis, generated by the Corporation’s loan portfolio decreased $205 thousand or 1.6% to $12.5 million for the three months ended September 30, 2008, compared to the same period in 2007. Interest income on loans decreased $262 thousand or 0.7% to $37.2 million for the nine months ended September 30, 2008, compared to the same period in 2007. The decrease        for the three month period is primarily due to a decrease in the average yield earned on loan and lease balances. The average yield decreased 81 basis points for the three months ended September 30, 2008 to 6.24% from 7.05% in the same period in 2007. The decrease was partially offset by an $82.3 million or 11.5% increase in the average balance of loans and leases outstanding. Interest income for the nine months ended September 30, 2007 includes the recognition of $282 thousand of        income related to the sale of a $5.9 million loan that had been on non-accrual status. Excluding this item, interest income for the nine months ended September 30, 2008 increased $20 thousand or 0.1% over the same period in 2007. This increase is primarily due to a $63.5 million or 8.9% increase in the average balance of loans and leases outstanding, partially offset by decreases in the average yield earned on loan portfolio from 7.05% in 2007 to 6.42% in 2008. The decreases in the        average yield earned on the loan portfolio for the three and nine months ended September 30, 2008 as compared to the same period in 2007 are primarily the result of Federal Reserve actions to reduce market interest rates.

 

**INTEREST EXPENSE**

 

Interest expense on deposit accounts decreased $1.7 million or 31.7% to $3.6 million for the three months ended September 30, 2008 compared to the same period in 2007. Interest expense on deposit accounts decreased $3.4 million or 21.8% to $12.1 million for the nine months ended September 30, 2008 compared to the same period in 2007. The decrease for the three months ended September 30, 2008 was due to a        110 basis point decrease in the average interest rates paid on these deposits partially offset by a $6.6 million or 1.1% increase in average total interest-bearing deposits. The decrease for the nine months ended September 30, 2008 was due to a 73 basis point decrease in the average interest rates paid on these deposits combined with a $201 thousand increase in average total interest-bearingdeposits. The decreases in the average interest rates paid on        deposits is primarily the result of Federal Reserve actions to reduce market interest rates combined with the decrease in higher cost brokered CD balances. Deposit balances have been affected by the Bank’s decision to replace higher cost brokered CDs with lower cost FHLB borrowings beginning in the second half of 2007. Excluding the decrease in average brokered CD balances, average total interest-bearing deposit balances would have increased by $62.1 million and $58.2 million for        the three and nine months ended, September 30, 2008, respectively, as compared to same periods in 2007.

 

Although market interest rates have declined, competition for deposits from other banks and non-banking institutions such as credit unions and mutual fund companies continues to be strong. This competition puts pressure on the pricing of the Corporation’s deposit base and on the cost of raising new deposits. As the Corporation competes for deposit dollars to fund its growth, alternative funding        sources continue to be explored.

 

Interest expense on subordinated debentures decreased $112 thousand to $209 thousand for the three month period ended September 30, 2008 from $321 thousand for the same period in 2007. Interest expense on subordinated debentures decreased $472 thousand to $683 thousand for the nine month period ended September 30, 2008 from $1.2 million when compared to the same period in 2007. The decreases for the three        and nine month periods ended September 30, 2008 were primarily due to a decrease in the average interest rate paid on these debentures resulting from market interest rate decreases. Interest expense on subordinated debentures for the nine month period ended September 30, 2007 includes a $161 thousand charge to interest expense recorded in the second quarter of 2007. The charge was for accelerated amortization of issuance costs related to the July 2007 early redemption of        $5.2 million of debentures that were issued by the First Chester County Corporation. The redemption of the debentures was coordinated with a new $5.2 million issuance on June 29, 2007. The new issuance bears an interest rate of 3 month LIBOR plus 140 basis points while the redeemed issuance had an interest rate of 3 month LIBOR plus 365 basis points.

 

20

 

 

----

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

Interest expense on Federal Home Loan Bank (“FHLB”) and other borrowings increased by $739 thousand or 101.1% to $1.5 million for the three month period ended September 30, 2008 from $731 thousand for the same period in 2007. This increase for the three month period ended September 30, 2008 is due to a $77.4 million or 104.5% increase in the average balances of these funding sources partially        offset by a 6 basis point decrease in the average interest rate paid on these borrowings. Interest expense on FHLB and other borrowings increased by $2.4 million or 125.2% to $4.4 million for the nine month period ended September 30, 2008 from $2.0 million for the same period in 2007. This increase for the nine month period ended September 30, 2008 is due to an $82.8 million or 122.9% increase in the average balances of these funding sources combined with a 4 basis point increase in the        average interest rate paid on these borrowing. The increase in average FHLB borrowings in 2008 as compared to 2007 is partially due to the Bank's decision to replace higher cost brokered CDs with lower cost FHLB borrowings beginning in the second half of 2007.  FHLB borrowings have been an alternative to deposits to support loan growth.

 

**PROVISION FOR LOAN AND LEASE LOSSES**

 

During the three and nine month periods ended September 30, 2008, the Corporation recorded a $290 and a $950 thousand provision for loan and lease losses compared to $0 for the same periods in 2007. The increase in the provision for loan and lease losses was driven mainly by an increase in non-accrual loans and loan growth combined with the effects of a slowing economy. The percentage of non-accrual loans        to gross loans was .38% at September 30, 2008 as compared to .16% at December 31, 2007 and .14% at September 30, 2007. The allowance for loan and lease losses as a percentage of loans at September 30, 2008 was 1.07% compared to 1.05% at December 31, 2007 and 1.12% at September 30, 2007. Net charge-offs were $190 thousand for the nine months ended September 30, 2008 as compared to $213 thousand in the same period in 2007.

 

The allowance for loan and lease losses is an amount that Management believes will be adequate to absorb possible loan losses on existing loans that may become uncollectible and is established based on Management’s evaluation of the collectability of loans. These evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality,        adequacy of collateral, review of specific problem loans, and current economic conditions that may affect our borrowers’ ability to pay.

 

 

 

 

 

21

 

 

----

**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

|   | **Three Months** | **Nine Months** |
|--------|------------------|-----------------|

|   | **Ended** | **Ended** |
|--------|-----------|-----------|

|   | **September 30,** | **September 30,** |
|--------|-------------------|-------------------|

|                                                      | **2008**                       |   | **2007**                       |   | **2008**                       |   | **2007**                       |
|-----------------------------------------------------------|--------------------------------|--------|--------------------------------|--------|--------------------------------|--------|--------------------------------|
|                                                      |                           |   |                           |   |                           |   |                           |
| Balance at beginning of period                            | $    8,433 |   | $    8,059 |   | $    7,817 |   | $    8,186 |
|                                                      |                           |   |                           |   |                           |   |                           |
| Provision charged to operating expense                    | 290                            |   | -                              |   | 950                            |   | -                              |
|                                                      |                           |   |                           |   |                           |   |                           |
| Recoveries of loans previously charged-off                | 36                             |   | 30                             |   | 233                            |   | 111                            |
| Loans charged-off                                         | (147)                          |   | (84)                           |   | (423)                          |   | (324)                          |
| Net loan (charge-offs) recoveries                         | (111)                          |   | (54)                           |   | (190)                          |   | (213)                          |
|                                                      |                           |   |                           |   |                           |   |                           |
| Allowance other adjustment (1)                            | 24                             |   | 36                             |   | 60                             |   | 68                             |
|                                                      |                           |   |                           |   |                           |   |                           |
| Balance at end of period                                  | $    8,637 |   | $    8,041 |   | $    8,637 |   | $    8,041 |
|                                                      |                           |   |                           |   |                           |   |                           |
| Period-end loans outstanding                              | $808,931                       |   | $719,530                       |   | $808,931                       |   | $719,530                       |
| Average loans outstanding                                 | $798,572                       |   | $716,243                       |   | $773,501                       |   | $709,991                       |
|                                                      |                           |   |                           |   |                           |   |                           |
| Allowance for loan and lease losses as a                  |                           |   |                           |   |                           |   |                           |
| percentage of period-end loans outstanding                | 1.07%                          |   | 1.12%                          |   | 1.07%                          |   | 1.12%                          |
| Net charge-offs (recoveries) to average loans outstanding | 0.01%                          |   | 0.01%                          |   | 0.02%                          |   | 0.03%                          |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1) The “Allowance other adjustment” represents the reclassification of an allowance for possible losses on unfunded loans and unused lines of credit. These loans and lines of credit, although unfunded, have been committed to by the Bank.

 

Non-performing loans and leases include those on non-accrual status and loans past due 90 days or more and still accruing. The Corporation’s policy is to write down all non-performing loans and leases to net realizable value based on current assessments of the value of the collateral securing such loans and leases and leases. Non-performing loans and leases are generally collateralized and are in        the process of collection. Non-accrual loans and leases reduce the Corporation’s earnings because interest income is not earned on such assets.

 

The Corporation held one commercial property classified as other real estate owned (“OREO”) at September 30, 2008. The corporation held no OREO properties as of September 30, 2007, and no OREO properties at December 31, 2007. OREO represents real estate owned by the Bank following default by the borrowers. OREO is recorded at the lower of the loan carrying value or fair market value.        Fair market value is based primarily upon independent market prices or professional appraisals.In the third quarter of 2008, the Bank wrote the value of the property held in OREO to market value based upon such factors. This resulted in $169 thousand charge to the “Gains (losses) on fixed assets and OREO” line of the income statement. OREO reduces the Corporation’s earnings        because interest income is not earned on such assets.

 

 

22

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

The following chart represents detailed information regarding non-performing loans and leases and OREO:

 

|   | (Dollars in thousands)   | September 30,   | December 31, |
|--------|------------------------------------|---------------------------|--------------|

|                                          | 2008    |   | 2007    |   | 2007    |
|-----------------------------------------------|---------|--------|---------|--------|---------|
|                                          |    |   |    |   |    |
| Past due over 90 days and still accruing      | $ 209   |   | $ 207   |   | $ 142   |
| Non-accrual loans and leases (1)              | 3,057   | (2)    | 986     |   | 1,194   |
| Total non-performing loans and leases         | 3,266   |   | 1,193   |   | 1,336   |
|                                          |    |   |    |   |    |
| Other real estate owned                       | 346     |   | -       |   | -       |
|                                          |    |   | -       |   | -       |
| Total non-performing assets                   | $ 3,612 |   | $ 1,193 |   | $ 1,336 |
|                                          |    |   |    |   |    |
| Non-performing loans and leases as a          |    |   |    |   |    |
| percentage of total loans and leases          | 0.40%   |   | 0.17%   |   | 0.18%   |
|                                          |    |   |    |   |    |
| Allowance for loan and lease losses as a      |    |   |    |   |    |
| percentage of non-performing loans and leases | 264.43% |   | 674.06% |   | 585.10% |
|                                          |    |   |    |   |    |
| Non-performing assets as a percentage of      |    |   |    |   |    |
| total loans and other real estate owned       | .45%    |   | 0.17%   |   | 0.18%   |
|                                          |    |   |    |   |    |
| Allowance for loan and lease losses as a      |    |   |    |   |    |
| percentage of non-performing assets           | 239.12% |   | 674.06% |   | 585.10% |

 

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

(2)   The $3.1 million non-accrual loan and lease balance shown in the table is different from the $3.6 million impaired loan balance

       discussed below due to $500 thousand performing loan that was categorized as inpaired at September 30, 2008.

 

Management is not aware of any loans or leases other than those included in these tables that would be considered potential problem loans and cause Management to have doubts as to the borrower’s ability to comply with loan repayment terms.

 

The Corporation identifies a loan as impaired when it is probable that interest and principal will not be collected according to the contractual terms of the loan agreement. The accrual of interest is discontinued on impaired loans and no income is recognized until all recorded amounts of interest and principal are recovered in full.

 

FASB 114 “Accounting by Creditors for Impairment of Loans” requires the Corporation to examine commercial and non-residential mortgage loans on non-accrual status for impairment. The balance of impaired loans was $3.6 million, $1.2 million, and $986 thousand at September 30, 2008, December 31, 2007, and September 30, 2007, respectively. The associated allowance for impaired loans was $233        thousand, $72 thousand, and $64 thousand at September 30, 2008, December 31, 2007, and September 30, 2007, respectively.

 

 

23

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

For the three and nine month periods ended September 30, 2008, activity in the allowance for impaired loan losses includes a provision of $184 and $213 thousand, respectively, and charge-offs of $0 and $6, respectively. There were no recoveries for the three and nine month periods ended September 30, 2008. Contractual interest amounted to $42 thousand and $98 thousand for the three and nine months ended        September 30, 2008, respectively. Total cash collected on impaired loans for the three and nine month periods ended September 30, 2008 was $262 thousand and $354 thousand all of which was applied to principal. Loans returned to performing for the three and nine month periods ended September 30, 2008 was $140 thousand and $160 thousand.

 

**NON-INTEREST INCOME**

 

Total non-interest income decreased 65.9% or $2.6 million to $1.3 million for the three months ended September 30, 2008, when compared to the same period in 2007. Total non-interest income decreased 23.4% or $2.1 million to $7.0 million for the nine month period ended September 30, 2008, when compared to the same period in 2007. The various components of non-interest income are discussed below.

 

Asset impairment for the three and nine months ended September 30, 2008 consists of a $1.3 million loss from the write down of two assets. The first, an $850 thousand pre-tax other than temporary impairment loss on a $1 million Lehman Brothers Note held in the Bank’s investment portfolio. The remaining $150 thousand is        presented on the “Investment securities available for sale” line of the Corporation’s Consolidated Balance Sheet.The second was a $417 pretax loss on a $13.9 million investment in the Reserve Primary Fund.The Reserve Primary Fund is a short term overnight money market fund designed to maintain a constant $1.00 per share value. The Bank typically uses this type of fund to invest excess        overnight cash. During the third quarter of 2008, the fund’s value fell below $1.00 per share due to underlying Lehman Brothers commercial paper in the fund. The fund is currently in process of liquidation. The Bank wrote its $13.9 million investment down to $13.5 million. The Bank expects to fully recover the remaining $13.5 million. The remaining $13.5 million is presented on the “Federal funds sold and other overnight investments” line        of the Corporation’s Consolidated Balance Sheet.

 

Wealth management and advisory services revenue, increased $7 thousand or .7% to $994 thousand for the three month period ended September 30, 2008 from $987 thousand during the same period in 2007. Wealth management and advisory services revenue increased $36 thousand or 1.2% to $3.1 million for the nine month period ended September 30, 2008 from $3.0 million during the same period in 2007. Wealth        management and advisory services revenue includes fee income from both the Wealth Management division of the Bank and the First National Financial Advisory Services subsidiary of the Bank. In the aggregate, wealth management and advisory services revenue consists primarily of fee income from services such as trust and portfolio management, estate management, insurance, full-service brokerage, financial planning and mutual fund services. Wealth management and advisory services revenue is        based partially on the market value of assets under management. The market value of assets under management at September 30, 2008 was $542.1 million compared to $594.9 million at September 30, 2007.

 

Service charges on deposit accounts increased $62 thousand or 10.4% to $657 thousand for the three month period ended September 30, 2008 compared to $595 thousand for the same period in 2007. For the nine month period ended September 30, 2008, service charges on deposit accounts increased $150 thousand or 8.8% to $1.9 million compared to $1.7 million for the same period in 2007. The increase in service        charges is primarily due to an increase in charges on retail and commercial demand deposit accounts.

 

The Corporation recognized a net gain of $89 thousand on sales of investment securities during the three month period ended September 30, 2008 compared with $0 during the same period in 2007. The Corporation recognized a net gain of $273 thousand on sales of investment securities during the nine month period ended September 30, 2008 compared with a net gain of $2 thousand during the same period in 2007.        These net gains and losses were taken as a result of normal portfolio management.

 

The Corporation has operating lease agreements with one customer. The income on these leases is classified as “Rental Income”. Rental Income on operating lease agreements increased $2 thousand or 0.5% to $328 thousand for the three months ended September 30, 2008 as compared to the same period in 2007. Rental Income on operating lease agreements increased $18 thousand or 1.9% to $967 thousand        for the for the nine months ended September 30, 2008 as compared to the same period in 2007.

 

24

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

Gains (losses) on fixed assets and OREO were losses of $123 thousand and $33 thousand for the three and nine month periods ended September 30, 2008 as compared to gains of $1.4 and $1.4 million for the same periods in 2007. The primary component of the losses for the three and nine month periods in 2008 was the $169 thousand write-down of property held as OREO that was discussed above. Partially        offsetting these losses were gains recorded in 2008 from the amortization of a deferred gain attributable to the sale-leaseback of facilities that occurred in the third quarter 2007. The gains recorded in 2007 are due to the $1.4 million of initial gain recorded in the third quarter of 2007 related to the sale lease-back transaction.

 

The nine month period ended September 30, 2007 includes a $225 thousand gain recorded in the second quarter of 2007 related to the sale of the $5.9 million loan as previously mentioned. Excluding this item, gains and fees on the sale of loans decreased $115 thousand or 36.9% for the nine months ended September 30, 2008 and decreased $85 thousand or 72.0% for the three months ended September 30, 2008        compared to the same periods in 2007. These decreases are mainly due to lower volume of originations and sales of residential mortgages during 2008 as compared to the same periods in 2007.

 

Bank-owned life insurance (“BOLI”) income relates to a $10 million policy purchased in February 2008. BOLI involves the purchase of a life insurance policy on a group of employees. The Bank is the owner and beneficiary of the policy. The BOLI investment is carried on the balance sheet at the cash surrender value of the underlying policies. Income or loss resulting from increases or decreases        in the cash surrender value of the properties is recorded on the income statement. BOLI gains for the three and nine month periods ended September 30, 2008 were $46 thousand and $203 thousand, respectively.

 

Other non-interest income increased $82 thousand or 16.8% to $570 thousand for the three months ended September 30, 2008 compared to same period in 2007. Other non-interest income increased $212 thousand or 14.3% to $1.7 million for the nine months ended September 30, 2008 compared to same period in 2007. The increases in other non-interest income were primarily due to increases in lease referral fees and        electronic banking fees. Other non-interest income also includes ATM surcharge revenue, STAR/Visa Check Card revenue, safe deposit box income, merchant services income, loan fee income, miscellaneous loan income, rental income and other miscellaneous income.

 

 

 

 

 

 

 

 

25

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

**NON-INTEREST EXPENSE**

 

Total non-interest expense increased $558 thousand or 6.9% to $8.6 million for the three months ended September 30, 2008, when compared to the same period in 2007. Total non-interest expense increased $579 thousand or 2.4% to $25.1 million for the nine months ended September 30, 2008, when compared to the same period in 2007. The various components of non-interest expense are discussed below.

 

Salaries and employee benefits increased $92 thousand or 1.9% for the three months ended September 30, 2008 compared to the same period in 2007. This is primarily due to an overall increase in salaries as well as an increase in severance costs. These increases were partially offset by a decrease in employee bonus expense. Salaries and employee benefits expense for the nine month periods ended September        30, 2008 includes a $417 thousand reduction of salary and benefits expense associated with loan origination costs not previously deferred in prior periods. Excluding the $417 thousand item, salaries and employee benefits decreased $86 thousand or .6% for the nine month period ended September 30, 2008 compared to the same period in 2007. This decrease is primarily due to a decrease in employee bonus expense partially offset by an increase in salaries and severance costs.

 

Net occupancy, equipment and data processing expense increased $191 thousand or 15.4% to $1.4 million during the three months ended September 30, 2008 when compared to the same period in 2007. Net occupancy, equipment and data processing expense increased $466 thousand or 12.0% to $4.3 million during the nine months ended September 30, 2008 when compared to the same period in 2007. The increase was mainly        due to the addition of the Longwood and Downingtown branches in the first quarter of 2008.

 

Depreciation on operating leases increased $4 thousand or 1.4% to $273 thousand for the three months ended September 30, 2008 when compared to the same period in 2007. Depreciation on operating leases increased $10 thousand or 1.3% to $799 thousand for the nine months ended September 30, 2008 when compared to the same period in 2007. This depreciation expense is the result of operating lease agreements        the Corporation has with one customer. The income associated with these operating leases is classified as Rental Income.

 

Expenses for professional services increased $20 thousand or 4.7% to $449 thousand for the three months ended September 30, 2008 when compared to the same period in 2007. Professional services expense decreased $57 thousand or 4.0% to $1.4 million for the nine months ended September 30, 2008 when compared to the same period in 2007. The decrease in professional fees for the nine month period is primarily        due to a reduction in legal fees related to the fact that the Corporation incurred additional costs in the first quarter of 2007 from compliance with new SEC executive compensation reporting requirements. These costs were not incurred in 2008.

 

Marketing expense decreased $7 thousand or 4.0% for the three months ended September 30, 2008 and decreased $3 thousand or .5% for the nine months ended September 30, 2008 as compared to the same periods in 2007.

 

 

 

 

26

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

Total other non-interest expense increased $211 thousand or 20.3% to $1.3 million for the three-month period ended September 30, 2008 compared to the same periods in 2007. Total other non-interest expense increased $555 thousand or 19.3% to $3.4 million for the nine months ended September 30, 2008 when compared to the same period in 2007. Other non-interest expense includes annual meeting and reports,        trust processing, postage, directors’ costs, telephone, travel and entertainment and operating supplies. The increase in other non-interest expense for the three and nine month periods ended September 30, 2008 is partially due to an increase in FDIC insurance premiums in 2008 as compared to 2007. FDIC insurance premium expense was $136 thousand and $347 thousand for the three and nine month periods ended September 30, 2008, as compared to $21 thousand and $64 thousand for the same        periods in 2007. The increase reflects the impact of 2006 legislation that increased FDIC premiums for all commercial banks. This legislation provided an assessment credit for each insured bank. The Bank’s assessment credit offset a larger portion of the insurance premium expense in 2007 than in 2008 and was fully utilized in the first quarter of 2008. The increased premium does not indicate any change in theFDIC risk assessment for the Bank. The increase in        other non-interest expense for the nine month period ended September 30, 2008 is also due to a $109 thousand charge taken in the first quarter of 2008 from the write-off of miscellaneous other assets.

 

**INCOME TAXES**

 

Income tax expense for the three and nine month periods ended September 30, 2008 was $148 thousand and $1.3 million, compared to $1.0 million and $2.3 million for the same periods in 2007. This represents an effective tax rate of 15.5% and 24.2% for the three and nine month periods ended September 30, 2008 compared with 27.1% and 27.8% for the same periods in 2007. The decreases in income tax expense        for the three and nine month periods are mainly due to increases in permanent differences as a relative percentage of pretax income. Permanent differences include non-taxable income such as tax-exempt interest on municipal securities and loans as well as BOLI income.

 

**LIQUIDITY MANAGEMENT AND INTEREST RATE SENSITIVITY**

 

The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all financial commitments and to capitalize on opportunities for business expansion. Liquidity management addresses the Corporation’s ability to meet deposit withdrawals either on demand or at contractual maturity, to repay borrowings as they mature, and to make new loans and investments as        opportunities arise. Liquidity is managed on a daily basis enabling Management to monitor changes in liquidity and to react accordingly to fluctuations in market conditions. The primary sources of liquidity for the Corporation are funding available from deposit growth, FHLB Borrowings, and cash flow from the investment and loan portfolios. Deposits consist of NOW, money-market, savings, tiered savings, large and small dollar certificates of deposit, and non-interest bearing demand        deposit accounts. The Corporation considers funds from NOW, money market, savings and certificates less than $100,000 as “core” deposits because of the historical stability of such sources of funds. Details of core deposits, non-interest bearing demand deposit accounts, and other deposit sources are highlighted in the following table:

 

 

 

 

27

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

|   | For the nine Months Ended   | For the Year Ended |
|--------|---------------------------------------|--------------------|

|   | (Dollars in thousands)   | September 30, 2008   | December 31, 2007 |
|--------|------------------------------------|--------------------------------|-------------------|

|                            | Average        |   | Effective |   | Average        |   | Effective |
|---------------------------------|----------------|--------|-----------|--------|----------------|--------|-----------|
| **DEPOSIT TYPE**                | Balance        |   | Yield     |   | Balance        |   | Yield     |
| NOW Accounts                    | $ 181,581 |   | 1.69%     |   | $ 159,572 |   | 2.30%     |
| Money Market                    | 115,690        |   | 2.60%     |   | 97,726         |   | 4.19%     |
| Statement Savings               | 40,360         |   | 0.71%     |   | 43,270         |   | 0.79%     |
| Other Savings                   | 2,939          |   | 1.52%     |   | 1,514          |   | 1.52%     |
| Tiered Savings                  | 50,497         |   | 1.31%     |   | 64,485         |   | 1.45%     |
| Total NOW, Savings, Money Mkt   | 391,067        |   | 1.81%     |   | 366,567        |   | 2.47%     |
|                            |           |   |      |   |           |   |      |
| CDs Less than $100,000          | 153,970        |   | 3.99%     |   | 192,236        |   | 4.72%     |
| CDs Greater than $100,000       | 72,392         |   | 4.08%     |   | 52,342         |   | 4.58%     |
| Total CDs                       | 226,362        |   | 4.02%     |   | 244,578        |   | 4.69%     |
|                            |           |   |      |   |           |   |      |
| Total Interest Bearing Deposits | 617,429        |   |      |   | 611,145        |   |      |
|                            |           |   |      |   |           |   |      |
| Non-Interest Bearing            |           |   |      |   |           |   |      |
| Demand Deposits                 | 118,776        |   |      |   | 121,000        |   |      |
|                            |           |   |      |   |           |   |      |
| Total Deposits                  | $ 736,205 |   |      |   | $ 732,145 |   |      |

 

The Bank, as a member of FHLB, maintains several credit facilities. During the three and nine month periods ended September 30, 2008, average FHLB advances were $151.5 million and $150.1 million, respectively, and consisted of term advances with a variety of maturities. The average interest rate on these advances was 3.9% and 3.9%, respectively. The Bank currently has a maximum borrowing

capacity with FHLB of approximately $230.9 million. FHLB advances are collateralized by a pledge on the Bank’s portfolio of unencumbered investment securities, certain mortgage loans, and a lien on the Bank’s FHLB stock.

 

From time to time, the Bank may take advantage of alternative sources of overnight borrowings from the Federal Reserve or correspondent banks. The Bank pledges certain loans as collateral for these lines of credit. At September 30, 2008 and 2007 the amounts of these types of advances outstanding were $0.

 

To supplement the Corporation’s sources of liquidity, the Corporation uses alternative funding sources such as brokered deposits and bringing off-balance sheet “swept” funds onto the balance sheet as deposits. Management has set limits for these funding sources and will manage the impact that such sources may have on liquidity and interest rate sensitivity.

 

The goal of interest rate sensitivity management is to avoid fluctuating net interest margins and to enhance consistent growth of net interest income through periods of changing interest rates. Such sensitivity is measured as the difference in the volume of assets and liabilities in the existing portfolio that are subject to re-pricing in a future time period. The Corporation’s net interest rate        sensitivity gap within one year is a negative $312.6 million or 31.2% of total assets at September 30, 2008 compared with a negative $168.2 million or 18.4% of total assets at December 31, 2007. The Corporation’s gap position is one tool used to evaluate interest rate risk and the stability of net interest margins. Another tool that management uses to evaluate interest rate risk is a computer simulation model that assesses the impact of changes in interest rates on net interest        income, net-income under various interest rate

 

28

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

forecasts and scenarios. Management has set acceptable limits of risk within its Asset Liability Committee (“ALCO”) policy and monitors the results of the simulations against these limits quarterly. As of the most recent quarter-end, all results are within policy limits and indicate an acceptable level of interest rate risk. Management monitors interest rate risk as a regular part of corporate        operationswith the intention of maintaining a stable net interest margin. The following table presents our interest sensitivity analysis as of September 30, 2008:

 

|                               |                                                                        |   | Two                                                                               |   | Over                                                                             |   |                                                                             |   |                                  |
|------------------------------------|-----------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------|--------|---------------------------------------|
| (Dollars in thousands)             | Within                                                                      |   | through                                                                           |   | five                                                                             |   | Non-rate                                                                         |   |                                  |
|                               | one year                                                                    |   | five years                                                                        |   | years                                                                            |   | sensitive                                                                        |   | Total                                 |
| ASSETS                             |                                                                        |   |                                                                              |   |                                                                             |   |                                                                             |   |                                  |
| Federal funds sold and             | $   14,581                                                   |   | $             -  |   | $             - |   | $             - |   | $     14,581 |
| overnight investments              |                                                                        |   |                                                                              |   |                                                                             |   |                                                                             |   |                                  |
| Investment securities              | 21,353                                                                      |   | 57,155                                                                            |   | 23,704                                                                           |   | -                                                                                |   | 102,212                               |
| Interest bearing deposits in banks | 207                                                                         |   | -                                                                                 |   | -                                                                                |   | -                                                                                |   | 207                                   |
| Net loans and leases               | 317,955                                                                     |   | 366,514                                                                           |   | 124,462                                                                          |   | (8,637)                                                                          |   | 800,294                               |
| Cash and due from banks            | -                                                                           |   | -                                                                                 |   | -                                                                                |   | 43,210                                                                           |   | 43,210                                |
| Premises and equipment             | -                                                                           |   | -                                                                                 |   | -                                                                                |   | 19,346                                                                           |   | 19,346                                |
| Other assets                       | -                                                                           |   | -                                                                                 |   | -                                                                                |   | 22,346                                                                           |   | 22,346                                |
| Total assets                       | $ 354,096                                                              |   | $ 423,669                                                                    |   | $ 148,166                                                                   |   | $    76,265                                                  |   | $ 1,002,196                      |
|                               |                                                                        |   |                                                                              |   |                                                                             |   |                                                                             |   |                                  |
| LIABILITIES AND CAPITAL            |                                                                        |   |                                                                              |   |                                                                             |   |                                                                             |   |                                  |
| Non-interest bearing deposits      | $             - |   | $              - |   | $             - |   | $   129,125                                                       |   | $   129,125            |
| Interest bearing deposits          | 606,920                                                                     |   | 21,477                                                                            |   | 3,997                                                                            |   | -                                                                                |   | 632,394                               |
| FHLB advances and other borrowings | 44,322                                                                      |   | 101,838                                                                           |   | 2,425                                                                            |   | -                                                                                |   | 148,585                               |
| Junior subordinated debentures     | 15,465                                                                      |   | -                                                                                 |   | -                                                                                |   | -                                                                                |   | 15,465                                |
| Other liabilities                  | -                                                                           |   | -                                                                                 |   | 9,274                                                                            |   | -                                                                                |   | 9,274                                 |
| Capital                            | -                                                                           |   | -                                                                                 |   | -                                                                                |   | 67,353                                                                           |   | 67,353                                |
| Total liabilities & capital    | $  666,707                                                        |   | $ 123,315                                                                    |   | $    15,696                                                  |   | $  196,478                                                             |   | $ 1,002,196                      |
| Net interest rate                  |                                                                        |   |                                                                              |   |                                                                             |   |                                                                             |   |                                  |
| sensitivity gap                    | $(312,611)                                                                  |   | $ 300,354                                                                    |   | $  132,470                                                             |   | $(120,213)                                                                       |   |                                  |
| Cumulative interest rate           |                                                                        |   |                                                                              |   |                                                                             |   |                                                                             |   |                                  |
| sensitivity gap                    | $(312,611)                                                                  |   | $    (12,257)                                                 |   | $  120,213                                                             |   | $             - |   |                                  |
| Cumulative interest rate           |                                                                        |   |                                                                              |   |                                                                             |   |                                                                             |   |                                  |
| sensitivity gap divided            |                                                                        |   |                                                                              |   |                                                                             |   |                                                                             |   |                                  |
| by total assets                    | (31.2%)                                                                     |   | (1.2%)                                                                            |   | 12.0%                                                                            |   |                                                                             |   |                                  |

 

The United States Treasury Department is making a voluntary capital investment program available to qualifying United States financial institutions and bank holding companies. The program, referred to as the "Capital Purchase Program," is intended to provide additional capital to institutions engaged in financial activities and to increase the flow of        financing to businesses and consumers and support the US economy. All US domiciled financial institutions and bank holding companies may participate in the Program, regardless of whether they are well-capitalized or not. The full terms of the Program have not been finalized, but the general terms that have been announced would permit FCCC to apply for a maximum subscription amount of approximately $25 million in the form of Senior Preferred Stock, bearing a cumulative dividend of        5% per annum for the first five years, resetting to 9% per annum after year five. According to the proposed term sheet, the Treasury Department would also receive warrants to purchase FCCC Common Stock with an aggregate market price equal to 15% of the Senior Preferred Stock investment. The exercise price on the warrants would be the market price on FCCC's Common Stock at the time the investment closes, calculated on a 20-trading day trailing average. FCCC is evaluating whether to        participate in the program and, if so, to what extent it would seek to do so.

 If FCCC decides to make an application to participate in the Program, the amount of the US Treasury Department's actual investment would not be known until such time as the Treasury Department receives and considers the applications from all such eligible institutions. If FCCC participates in the Program, it will be required to adopt the Treasury Department's standards        for executive compensation and corporate governance, for the period during which the Treasury Department holds equity issued under the Program.

 

29

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

**BRANCHING, TECHNOLOGY AND CAPITAL PROJECTS**

 

During the first quarter of 2008, the Bank opened two new branch facilities. The first, a newly constructed, full-service branch located in Kennett Square, Pennsylvania, features the Bank’s signature building design, first showcased by the Oxford Branch, which opened in 2005. The second, a full-service branch located in Downingtown, Pennsylvania, replaced the Coatesville Branch. The Coatesville        branch was closed in the first quarter of 2008. Technological improvements, including enhanced security over customer information, a more proactive disaster recovery system and an improved infrastructure to support more internet banking products are also expected in the future. We are continuously looking for opportunities to expand our branch system and invest in technology to better serve our customers.

 

**PROPOSED ACQUISITION**

 

On September 18, 2008, the Corporation and the Bank entered into an Agreement and Plan of Merger with American Home Bank, National Association (“AHB”) pursuant to which all of the outstanding shares of AHB will be exchanged for and converted to cash and shares of the Corporation, and AHB will be merged with and into the Bank, a wholly-owned subsidiary of the Corporation. Under the terms of the        Merger Agreement, AHB shareholders may elect to receive either 0.7000 shares of common stock of the Corporation or cash equal to $11.00 per share of AHB common stock, in each case, subject to adjustment in certain circumstances. Shareholder elections are subject to allocation procedures, which are intended to ensure that approximately 90% of the consideration to be paid by the Corporation will be in the form of common stock and approximately 10% of the consideration will be in cash,        assuming no reduction to the purchase price. The total value of the merger consideration is approximately $18.2 million based on the Corporation’s closing price of $15.25 per share on September 18, 2008. The cash portion of the purchase price will be paid out of the Corporation's current operations and without third party financing.

 

AHB is a national bank with assets of approximately $268 million as of June 30, 2008, offering consumer and commercial banking services through two branch offices in Mountville and Carlisle in central Pennsylvania, and has a significant mortgage banking operation. During the twelve months ended August 31, 2008, AHB originated approximately $1 billion in residential mortgage loans to qualified borrowers        with good credit histories and complete documentation. Such residential mortgage loans are generally conventional conforming, jumbo, FHA and VA loans, as well as construction to permanent loans for homeowners. Both the Bank and AHB avoid funding sub-prime mortgages. Following the merger, the consumer and commercial banking services of AHB and its branch offices will be merged into the banking operations of the Bank, and the AHB mortgage banking operations will be run as a separate        division of the Bank under the American Home Bank name.

 

The transaction, which is expected to close in the fourth quarter of 2008, is subject to shareholder approval by AHB shareholders, customary regulatory approvals and other customary conditions provided for in the Merger Agreement. The Corporation has filed a Registration Statement on Form S-4 with the SEC in connection with this transaction to register the shares of common stock that will be issued at        closing. This Registration Statement was declared effective on October 31, 2008. No assurance can be given that all required approvals will be obtained, that all other closing conditions will be satisfied or waived, or that the transaction will in fact be consummated.

 

 

30

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS – Continued**

 

**CAPITAL****ADEQUACY**

 

The Corporation is subject to Risk-Based Capital Guidelines adopted by the Federal Reserve Board for bank holding companies. The Corporation is also subject to similar capital requirements adopted by the Office of the Comptroller of the Currency. Under these requirements, the regulatory agencies have set minimum thresholds for Tier I Capital, Total Capital, and Leverage ratios. At September 30, 2008, both        the Corporation’s and the Bank’s capital exceeded all minimum regulatory requirements, and the Bank was considered “well capitalized” as defined in the regulations issued pursuant to the FDIC Improvement Act of 1992.

 

|   | As of September 30,   | As of December 31,   | ”Well Capitalized” |
|--------|---------------------------------|--------------------------------|--------------------------------|

|                           | 2008                      |   | 2007        |   | 2007   |   | Requirements |
|--------------------------------|---------------------------|--------|-------------|--------|--------|--------|--------------|
| Corporation                    |                      |   |        |   |   |   |         |
| Leverage Ratio                 |   8.66%              |   |  9.13% |   | 9.22%  |   | N/A          |
| Tier I Capital Ratio           | 10.04%                    |   | 10.84%      |   | 10.84% |   | N/A          |
| Total Risk-Based Capital Ratio |     11.10% |   | 11.95%      |   | 11.92% |   | N/A          |
| Bank                           |                      |   |        |   |   |   |         |
| Leverage Ratio                 |  8.03%               |   | 8.47%       |   | 8.58%  |   | 5.00%        |
| Tier I Capital Ratio           |  9.31%               |   | 10.06%      |   | 10.08% |   | 6.00%        |
| Total Risk-Based Capital Ratio | 10.38%                    |   | 11.19%      |   | 11.18% |   | 10.00%       |

 

The Bank is not under any agreement with the regulatory authorities nor is it aware of any current recommendations by the regulatory authorities that, if they were to be implemented, would have a material affect on liquidity, capital resources, or operations of the Corporation.

 

 

31

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

There have been no material changes in the Corporation’s assessment of its sensitivity to market risk since its presentation in the 2007 Annual Report. Please refer to Item 7A on pages 36-38 of the Corporation’s 2007 Annual Report for more information.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

**Disclosure Controls and Procedures.**Included with this Quarterly Report as Exhibits 31.1, 31.2, and 31.3 are certifications (the “Section 302 Certifications”), one by each of our Chief Executive Officer, President and Chief Financial Officer (our principal executive, operating and financial officers, respectively, and, collectively, the “Principal        Officers”). This section of the Quarterly Report contains information concerning the evaluations of our disclosure controls and procedures and internal control over financial reporting that are referred to in the Section 302 Certifications. This information should be read in conjunction with the Section 302 Certifications for a more complete understanding of the topics presented.

 

The SEC requires that as of the end of the quarter covered by this Report, our CEO and CFO evaluate the effectiveness of the design and operation of our disclosure controls and procedures and report on the effectiveness of the design and operation of our disclosure controls and procedures.

 

“Disclosure controls and procedures” mean the controls and other procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 (the “Exchange Act”), such as this Quarterly Report, is recorded, processed, summarized and reported within the time periods specified in the rules and        forms promulgated by the SEC. Disclosure controls and procedures are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the Principal Officers, as appropriate, to allow timely decisions regarding required disclosure.

 

**Management’s Report on Disclosure Controls and Procedures.**As required by Rule 13a-15(b), under the Exchange Act, Management, including our Principal Officers, conducted an evaluation as of the end of the period covered by this report, of the effectiveness of the Corporation’s disclosure controls and procedures. Based on that evaluation, the Principal Officers        concluded that our disclosure controls and procedures were effective, as of September 30, 2008, at the reasonable assurance level, to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed and reported within the time periods specified in the SEC rules and regulations.

 

**Changes in internal control over financial reporting.**In connection with the ongoing review of the Corporation’s internal control over financial reporting (as defined in Rule 13a-15(d), under the Exchange Act), Management, including the Principal Officers, regularly assesses the adequacy of the Corporation’s internal control over financial reporting to determine        whether any changes occurred during the period covered by this Report that have materially affected, or are reasonably likely to materially affect, the Corporation’s internal control over financial reporting.During the third quarter of 2008, there were no such changes.

 

 

 

 

32

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION**

 

| **Item 1.** | **Legal Proceedings** |
|-------------|-----------------------|

 

Various actions and proceedings are presently pending to which the Corporation is a party. These actions and proceedings arise out of routine operations and, in Management’s opinion, will not, either individually or in the aggregate, have a material adverse effect on the consolidated financial position of the Corporation and its subsidiaries.

 

| **Item 1A.** | **Risk Factors** |
|--------------|------------------|

 

In addition to the information contained in this report, you should carefully consider the risk factors disclosed in our 2007 Annual Report, as supplemented and updated below.

 

The following risk factor relating to our business has been updated since we filed our 2007 Annual Report:

***Adverse changes in the economic conditions in our market area could materially and negatively affect our business.***

Substantially all of our business is with consumers and small to mid-sized companies located within Chester and Delaware Counties, Pennsylvania. Our business is directly affected by factors such as economic, political and market conditions, broad trends in industry and finance, legislative and regulatory changes, changes in government monetary and fiscal policies and inflation, all of        which are beyond its control. A deterioration in economic conditions, whether caused by national, regional or local concerns, including an economic slowdown in southeastern Pennsylvania, could result in the following consequences, any of which could materially harm our business and operating results:

• customer’s credit quality may deteriorate;

• loan delinquencies and losses may increase;

• problem assets and foreclosures may increase;

• fluctuations in the value of, or impairment losses with respect to, investment securities;

• need to increase our allowance for loan and lease losses, thus reducing net income;

• more non-accrual loans may reduce net income;

• demand for our products and services may decrease;

• competition for low cost or non-interest bearing deposits may increase; and

• collateral securing loans may decline in value.

 

The risk factors set forth below, relating to the pending merger with, and the business of, American Home Bank (“AHB”), have been added since we filed our 2007 Annual Report.

 

As described below and in our Amendment No. 1 to Registration Statement on Form S-4, filed with the SEC on October 30, 2008 (the “Form S-4”), the merger must be approved by multiple governmental agencies and by the shareholders of AHB and is subject to satisfaction or waiver of various conditions. Thus, there can be no assurance that the merger will be completed.

 

 

33

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION - CONTINUED**

 

**Risk Factors Related to the Merger**

***The merger must be approved by multiple governmental agencies that may impose conditions that could delay closing, reduce the merger consideration or burden the future operations of AHB and FCCC after completion of the merger.***

Neither American Home Bank nor First Chester County is obligated to complete the merger if various regulatory approvals are not obtained. Before the merger may be completed, approvals or consents must be obtained from the Federal Reserve Board, the Office of the Comptroller of Currency and the Pennsylvania Department of Banking. These governmental entities may impose conditions on the completion of the        merger or require changes to the terms of the merger agreement. Although First Chester County and American Home Bank do not currently expect that any such conditions or changes would be imposed, there can be no assurance that they will not be. If any conditions or changes are imposed on the parties by these governmental authorities, this could have the effect of delaying completion of the merger or imposing additional costs on the parties which may result in an adjustment to the amount        of cash and stock paid for shares of American Home Bank in the merger.

***The merger must be approved by multiple governmental agencies that may impose conditions that could delay closing, reduce the merger consideration or burden the future operations of AHB and FCCC after completion of the merger.***

Neither American Home Bank nor First Chester County is obligated to complete the merger if various regulatory approvals are not obtained. Before the merger may be completed, approvals or consents must be obtained from the Federal Reserve Board, the Office of the Comptroller of Currency and the Pennsylvania Department of Banking. These governmental entities may impose conditions on the completion of the        merger or require changes to the terms of the merger agreement. Although First Chester County and American Home Bank do not currently expect that any such conditions or changes would be imposed, there can be no assurance that they will not be. If any conditions or changes are imposed on the parties by these governmental authorities, this could have the effect of delaying completion of the merger or imposing additional costs on the parties which may result in an adjustment to the amount        of cash and stock paid for shares of American Home Bank in the merger.

***First Chester County may fail to realize all of the anticipated benefits of the merger.***

The success of the merger will depend, in part, on First Chester County’s ability to realize the anticipated benefits and cost savings from combining the businesses of First Chester County and American Home Bank. However, to realize these anticipated benefits and cost savings, First Chester County must successfully combine the businesses of First Chester County and American Home Bank. If First        Chester County is not able to achieve these objectives, the anticipated benefits and cost savings of the merger may not be realized fully or at all or may take longer to realize than expected.

 

 

34

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION - CONTINUED**

 

***Combining American Home Bank into First Chester County may be more difficult, costly or time-consuming than expected.***

First Chester County and American Home Bank have operated, and, until the completion of the consolidation, will continue to operate, independently. The integration process could result in the loss of key employees, the disruption of each company’s ongoing business, inconsistencies in standards, controls, procedures and policies that adversely affect either company’s ability to maintain        relationships with clients and employees or achieve the anticipated benefits of the consolidation. As with any consolidation of financial institutions, there also may be disruptions that cause First Chester County and American Home Bank to lose customers or cause customers to withdraw their deposits from American Home Bank or First National Bank, or other unintended consequences that could have a material adverse effect on First Chester County’s results of operations or financial        condition.

***Due to accounting rule changes, failure to complete the merger by December*** ***31, 2008 will result in additional charges for First Chester County in 2009.***

On December 4, 2007, the Financial Accounting Standards Board issued a revised version of Financial Accounting Standard No. 141 (“FAS 141(R)”), which addresses accounting for business combinations. Prior to the effective date of FAS 141(R), the costs of an acquisition—such as legal, consulting, banking and other professional fees related to an acquisition—have        been and will be capitalized as part of the purchase price of the transaction. After December 31, 2008, when FAS 141(R) will become effective for First Chester County, transaction-related costs of an acquisition must be expensed during the period in which they are incurred. Accordingly, if the merger is not completed until after December 31, 2008, transaction related costs will be expensed, and First Chester County’s earnings will be reduced accordingly.

***The issuance of First Chester County common stock in connection with the merger could decrease the market price of First Chester County common stock.***

First Chester County will issue up to 1,055,625 shares of First Chester County common stock, or approximately 16.9% of the number of outstanding shares of First Chester County common stock taking into account such issuance, to American Home Bank shareholders in the merger. The issuance of these additional shares of First Chester County common stock may result in a reduction in the price per share of First        Chester County common stock.

**Risk Factors Related to American Home Bank’s Business**

Following consummation of the merger, First National Bank will establish a division comprised of American Home Bank’s current mortgage-banking operation. American Home Bank’s business is subject to substantially all of the risk factors set forth for First Chester County in its 2007 Annual Report, as updated above. Consequently, the following risk factors related to American Home Bank’s        business should be read in conjunction with the First Chester County risk factors. The following risk factors relate solely to American Home Bank’s current business which will become a division of First National Bank following consummation of the merger.

 

35

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION - CONTINUED**

 

***Weakness in the real estate market, including the secondary residential mortgage loan markets, has adversely affected American Home Bank and may adversely affect the American Home Bank division of First Chester County following the merger.***

Significant ongoing disruptions in the secondary market for residential mortgage loans have limited the market for and liquidity of many mortgage loans. The effects of ongoing mortgage market challenges, combined with the ongoing correction in residential real estate market prices and reduced levels of home sales, could result in further price reductions in single family home values, adversely affecting        the value of collateral securing mortgage loans that American Home Bank holds, mortgage loan originations and profits on sale of mortgage loans, or adversely affecting American Home Bank’s customers’ ability to repay their loans. Declining real estate prices and higher interest rates have caused higher delinquencies and losses on certain mortgage loans. These trends could continue. Continued declines in real estate values, home sales volumes and financial stress on borrowers        as a result of job losses, interest rate resets on adjustable rate mortgage loans or other factors could have further adverse effects on borrowers that result in higher delinquencies, greater charge-offs, and increased demands for repurchases, indemnification claims or litigation in future periods, which could adversely affect American Home Bank’s financial condition or results of operations.

***American Home Bank could be required to repurchase mortgage loans or indemnify mortgage loan purchasers as a result of breaches of representations and warranties, borrower fraud, or certain borrower defaults, which could harm liquidity, results of operations and financial condition.***

When American Home Bank sells mortgage loans, whether as whole loans or pursuant to a securitization, American Home Bank is required to make customary representations and warranties to the purchasers about the mortgage loans and the manner in which they were originated. American Home Bank’s whole loan sale agreements require American Home Bank to repurchase or substitute mortgage loans in the event        American Home Bank breaches any of these representations or warranties. In addition, American Home Bank may be required to repurchase mortgage loans as a result of borrower fraud or in the event of early payment default of the borrower on a mortgage loan. Likewise, American Home Bank is required to repurchase or substitute mortgage loans if American Home Bank breaches a representation or warranty in connection with its securitizations. The remedies available to American Home Bank        against the originating broker or correspondent may not be as broad as the remedies available to a purchaser of mortgage loans against American Home Bank, and American Home Bank faces the further risk that the originating broker or correspondent may not have the financial capacity to perform remedies that otherwise may be available to American Home Bank. Therefore, if a purchaser enforces its remedies, American Home Bank may not be able to recover its losses from the originating broker        or correspondent. If repurchase and indemnity demands increase, American Home Bank’s liquidity, results of operations and financial condition will be adversely affected.

 

 

 

36

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION - CONTINUED**

***American Home Bank’s dependence on certain relationships, such as with Freddie Mac, could adversely affect American Home Bank’s business.***

The secondary mortgage markets are currently experiencing unprecedented disruptions resulting from reduced investor demand for mortgage loans and mortgage-backed securities and increased investor yield requirements for those loans and securities. In addition, American Home Bank has a substantial relationship with Freddie Mac, including loan sales that are material to American Home Bank’s business. A        significant portion of the conventional loans that American Home Bank originates or purchases qualify for inclusion in guaranteed mortgage securities backed by Freddie Mac. A substantial reduction in the volume of loans that Freddie Mac agrees to purchase or the loss of other material financial benefits American Home Bank receives from Freddie Mac could have a material adverse effect on American Home Bank’s results of operation and financial condition. As a government-sponsored        enterprise, Freddie Mac is subject to extensive regulation and oversight by governmental agencies. On September 7, 2008, Freddie Mac was placed under the conservatorship of the Federal Housing Finance Agency, Freddie Mac’s principal regulator. Substantial changes in Freddie Mac’s business and operations are anticipated to occur as a result of such event. This event, together with changes in regulations or the occurrence of other events that adversely impact the        business, operations or prospects of Freddie Mac could have a material adverse effect on American Home Bank’s business, operations or prospects.

***The scope of American Home Bank’s residential mortgage loan production exposes it to risks of noncompliance with an increasing and inconsistent body of complex laws and regulations at the federal, state and local levels in the United States.***

 

Because American Home Bank is authorized to originate, purchase and service mortgage loans in all 50 states, it must comply with the laws and regulations, as well as judicial and administrative decisions, for all of these jurisdictions, in addition to an extensive body of federal law and regulations. The volume of new or modified laws and regulations has increased in recent years, and        individual cities and counties in the United States have begun to enact laws that restrict certain loan origination, acquisition and servicing activities in those cities and counties. The laws and regulations are different, complex and, in some cases, in direct conflict with each other or contain vague standards or requirements, which make compliance efforts challenging.

 

|   | American Home Bank’s failure to comply with these laws can lead to: |
|--------|---------------------------------------------------------------------------|

• civil and criminal liability:

• loss of licenses and approvals;

• damage to its reputation in the industry;

• inability to sell or securitize its loans, or otherwise raise capital;

• demands for indemnification or loan repurchases from purchasers of its loans;

• fines and penalties and litigation, including class action lawsuits;

• administrative enforcement actions;

• additional regulatory burdens, restrictions, or other changes to American Home Bank’s business model;

• claims that an allegedly non-compliant loan is rescindable or unenforceable; and

• damage to the reputation of American Home Bank or the American Home Bank division of First National Bank, any of which could have a material adverse effect on American Home Bank’s business, operations or prospects.

 

37

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION - CONTINUED**

***American Home Bank relies on other companies to provide key components of its business infrastructure.***

Third parties provide key components of American Home Bank’s business infrastructure, such as banking services, processing, and Internet connections and network access. Any disruption in such services provided by these third parties or any failure of these third parties to handle current or higher volumes of use could adversely affect American Home Bank’s ability to deliver products and        services to clients and otherwise to conduct business. Technological or financial difficulties of a third party service provider could adversely affect American Home Bank’s business to the extent those difficulties result in the interruption or discontinuation of services provided by that party. American Home Bank may not be insured against all types of losses as a result of third party failures and American Home Bank’s insurance coverage may be inadequate to cover all        losses resulting from system failures or other disruptions. Failures in American Home Bank’s business infrastructure could interrupt the operations or increase the costs of doing business.

***Significant legal actions could subject American Home Bank to substantial liabilities or litigation costs.***

American Home Bank is currently involved in various claims and legal actions related to its operations. In general, such matters are believed to be ordinary routine litigation incidental to the conduct of business. Nonetheless, the costs to pursue and defend these legal matters may be significant, and if the claims were determined against American Home Bank, could adversely affect the results of        operations, financial condition, reputation and prospects of American Home Bank or the American Home Bank division of First National Bank.

***The use of correspondents, brokers and other third parties to originate loans outside of its market area subjects American Home Bank to certain risks.***

American Home Bank utilizes mortgage correspondents and brokers to originate mortgage loans, including construction/permanent loans, beyond its local market area. This use of correspondents and brokers may increase the risk of fraudulent representations of a borrower’s creditworthiness. American Home Bank utilizes independent licensed appraisers and inspectors to appraise and inspect properties and        work progress on construction/permanent loans, but American Home Bank employees may not be present in many of these markets. Thus, American Home Bank relies on the professional opinions and photographic evidence provided by appraisers and inspectors to authorize periodic advances in accordance with applicable loan documents. This reliance may increase the risk of errors or fraud regarding the approval of loans and the making of loan advances.

***American Home Bank faces prepayment risk from loans sold for which servicing is retained.***

Mortgage loans sold, for which servicing is retained, are subject to prepayment risk. Statement of Financial Accounting Standards No. 156 requires capitalization of the fair value of originated mortgage servicing rights. If mortgages are repaid faster than the estimated rate used in capitalizing the mortgage servicing rights, the fair value of the mortgage servicing rights would decrease and be        reflected as a charge against earnings. American Home Bank’s focus on residential mortgage lending could cause the risk of loss from mortgage prepayments to be material.

 

38

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION - CONTINUED**

***American Home Bank’s profitability has not been consistent.***

American Home Bank was formed in 2001. Since that time, American Home Bank has not achieved a record of consistent profitability. There is no assurance that following the merger the American Home Bank division of First Chester County will achieve profitability in the foreseeable future.

| **Item 2.** | **Unregistered Sales of Equity Securities and Use of Proceeds** |
|-------------|-----------------------------------------------------------------|

 

**ISSUER PURCHASES OF EQUITY SECURITIES**(1)

 

|  

 

Period            | (a)

Total Number of Shares (or

Units)

Purchased | (b)

Average

Price Paid

per Share

(or Unit) | (c)

Total Number of Shares (or Units) Purchased as Partof Publicly Announced Plans

or Programs (1) | (d)

Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs (1) |
|-----------------------------------|----------------------------------------------------|------------------------------------------------|------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------------------------------------|
| July 1 to July 31, 2008           | --                                                 | --                                             | --                                                                                                   | $10,000,000                                                                                                                      |
| August 1 to August 31, 2008       | --                                                 | --                                             | --                                                                                                   | $10,000,000                                                                                                                      |
| September 1 to September 30, 2008 | --                                                 | --                                             | --                                                                                                   | $10,000,000                                                                                                                      |
| Total                             | --                                                 | --                                             | --                                                                                                   | $10,000,000                                                                                                                      |

 

(1) The Corporation announced on November 16, 2007 a program to repurchase up to $10.0 million of the Corporation’s Common Stock. This program replaced a previous program that expired in October 2007.

 

 

 

 

 

 

 

 

39

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION - CONTINUED**

 

| **Item 3.** | **Defaults upon Senior Securities** |
|-------------|-------------------------------------|

 

None

 

| **Item 4.** | **Submission of Matters to a Vote of Security Holders** |
|-------------|---------------------------------------------------------|

 

None

 

| **Item 5.** | **Other Information** |
|-------------|-----------------------|

 

None

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

40

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**PART II - OTHER INFORMATION - CONTINUED**

 

| **Item 6.** | **Exhibits** |
|-------------|--------------|

 

Exhibits marked as “(cp)” are management contracts or compensatory plans, contracts or arrangements in which a director or executive officer participates or may participate. Exhibits marked with an asterisk are filed with this report.

 

2.1 Agreement and Plan of Merger, dated as of September 18, 2008, by and among First Chester County Corporation, First National Bank of Chester County and American Home Bank, National Association, is incorporated herein by reference to Exhibit 2.1 to the Corporation’s Current Report on Form 8-K filed on September 19, 2008.

 

3(i).    Corporation’s Articles of Incorporation, as amended, are incorporated herein by reference to Exhibit 3 (i) to the Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2004.

 

3(ii).  Corporation’s Bylaws, as amended, are incorporated herein by reference to Exhibit 3(ii) to the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2007.

 

10.1 Employment Agreement, dated September 18, 2008, by and between First Chester County Corporation, First National Bank of Chester County and James M. Deitch, is incorporated herein by reference to Exhibit 10.1 to the Corporation’s Current Report on Form 8-K filed on September 19, 2008. (CP)

 

10.2 Employment Agreement, dated September 18, 2008, by and between First Chester County Corporation, First National Bank of Chester County and Anna Ruth Smith, is incorporated herein by reference to Exhibit 10.2 to the Corporation’s Current Report on Form 8-K filed on September 19, 2008. (CP)

 

10.3 Support Agreement, dated September 18, 2008, by and between First Chester County Corporation and Franklin Financial Services Corporation, is incorporated herein by reference to Exhibit 10.3 to the Corporation’s Current Report on Form 8-K filed on September 19, 2008.

 

|   | 31.1 | Rule 13a-14(a) Certification of Chief Executive Officer* |
|--------|------|----------------------------------------------------------|

|   | 31.2 | Rule 13a-14(a) Certification of President* |
|--------|------|--------------------------------------------|

|   | 31.3 | Rule 13a-14(a) Certification of Chief Financial Officer* |
|--------|------|----------------------------------------------------------|

 

|   | 32.1 | Section 906 Certification of the Chief Executive Officer* |
|--------|------|-----------------------------------------------------------|

|   | 32.2 | Section 906 Certification of the President* |
|--------|------|---------------------------------------------|

|   | 32.3 | Section 906 Certification of the Chief Financial Officer* |
|--------|------|-----------------------------------------------------------|

 

 

41

 

 

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**FIRST CHESTER COUNTY CORPORATION AND SUBSIDIARIES**

 

**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

**FIRST CHESTER COUNTY CORPORATION**

 

 

 

| **November 10, 2008** | **__/s/ John A. Featherman**______________________ |
|-----------------------|----------------------------------------------------|
|                  | **John A. Featherman, III**                        |
|                  | **Chief Executive Officer**                        |
|                  |                                               |
|                  |                                               |
|                  |                                               |
|                  |                                               |
| **November 10, 2008** | **__/s/ John E. Balzarini______________________**  |
|                  | **John E. Balzarini**                              |
|                  | **Chief Financial Officer**                        |
|                  | **(Principal Financial and Accounting Officer)**   |
|                  |                                               |

 

 

42

 

 

----

**INDEX TO EXHIBITS**

 

The following is a list of the exhibits filed with, or incorporated by reference into, this Report (those exhibits marked with an asterisk are filed herewith and those marked “(cp)” are management contracts or compensatory plans, contracts or arrangements in which a director or executive officer participates or may participate):

 

2.1 Agreement and Plan of Merger, dated as of September 18, 2008, by and among First Chester County Corporation, First National Bank of Chester County and American Home Bank, National Association, is incorporated herein by reference to Exhibit 2.1 to the Corporation’s Current Report on Form 8-K filed on September 19, 2008.

 

3(i). Corporation’s Articles of Incorporation, as amended, are incorporated herein by reference to Exhibit 3 (i) to the Corporation’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2004.

 

3(ii). Corporation’s Bylaws, as amended, are incorporated herein by reference to Exhibit 3(ii) to the Corporation’s Annual Report on Form 10-K for the year ended December 31, 2007.

 

10.1 Employment Agreement, dated September 18, 2008, by and between First Chester County Corporation, First National Bank of Chester County and James M. Deitch, is incorporated herein by reference to Exhibit 10.1 to the Corporation’s Current Report on Form 8-K filed on September 19, 2008. (CP)

 

10.2 Employment Agreement, dated September 18, 2008, by and between First Chester County Corporation, First National Bank of Chester County and Anna Ruth Smith, is incorporated herein by reference to Exhibit 10.2 to the Corporation’s Current Report on Form 8-K filed on September 19, 2008. (CP)

 

10.3 Support Agreement, dated September 18, 2008, by and between First Chester County Corporation and Franklin Financial Services Corporation, is incorporated herein by reference to Exhibit 10.3 to the Corporation’s Current Report on Form 8-K filed on September 19, 2008.

 

|   | 31.1 | Rule 13a-14(a) Certification of Chief Executive Officer* |
|--------|------|----------------------------------------------------------|

|   | 31.2 | Rule 13a-14(a) Certification of President * |
|--------|------|---------------------------------------------|

|   | 31.3 | Rule 13a-14(a) Certification of Chief Financial Officer* |
|--------|------|----------------------------------------------------------|

 

|   | 32.1 | Section 906 Certification of the Chief Executive Officer* |
|--------|------|-----------------------------------------------------------|

|   | 32.2 | Section 906 Certification of the President* |
|--------|------|---------------------------------------------|

|   | 32.3 | Section 906 Certification of the Chief Financial Officer* |
|--------|------|-----------------------------------------------------------|

 

43