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Management Discussion and Analysis

3 Months Ended

Jun. 30, 2011

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following narrative is Management’s discussion and analysis of the foremost factors that influenced 1^stFranklin Financial Corporation’s and its consolidated subsidiaries’ (the “Company”, “our” or “we”) financial condition and operating results as of and for the three- and six-month periods ended June 30, 2011 and 2010. This analysis and the accompanying unaudited condensed consolidated interim financial information should be read in conjunction with the audited consolidated financial statements and related notes included in the Company’s 2010 Annual Report. Results achieved in any interim period are not necessarily reflective of the results to be expected for any other interim or full year period.

Forward-Looking Statements:

Certain information in this discussion, and other statements contained in this Quarterly Report which are not historical facts, may be forward-looking statements within the meaning of the federal securities laws. Such forward-looking statements involve known and unknown risks and uncertainties. The Company's actual results, performance or achievements could differ materially from those contemplated, expressed or implied by the forward-looking statements contained herein. Possible factors which could cause actual future results to differ from expectations include, but are not limited to, adverse general economic conditions, including changes in the interest rate environment, unexpected reductions in the size of or collectability of amounts in our loan portfolio, reduced sales or increased redemptions of our securities, unavailability of borrowings under our credit facility, federal and state regulatory changes affecting consumer finance companies and unfavorable outcomes in legal proceedings and developments in any of the matters described under “Risk Factors” in our 2010 Annual Report, as well as other factors referenced elsewhere in our filings with the Securities and Exchange Commission from time to time. The Company undertakes no obligation to update any forward-looking statements, except as required by law.

The Company:

We are engaged in the consumer finance business, primarily in making consumer loans to individuals in relatively small amounts for short periods of time. Other lending-related activities include the purchase of sales finance contracts from various dealers and the making of first and second mortgage real estate loans on real estate. As of June 30, 2011, the Company’s business was operated through a network of 255 branch offices located in Alabama, Georgia, Louisiana, Mississippi, South Carolina and Tennessee.

We also offer optional credit insurance coverage to our customers when making a loan. Such coverage may include credit life insurance, credit accident and health insurance, and/or credit property insurance. Customers may request credit life insurance coverage to help assure that any outstanding loan balance is repaid if the customer dies before the loan is repaid or they may request accident and health insurance coverage to help continue loan payments if the customer becomes sick or disabled for an extended period of time. Customers may also choose property insurance coverage to protect the value of loan collateral against damage, theft or destruction. We write these various insurance policies as an agent for a non-affiliated insurance company. Under various agreements, our wholly-owned insurance subsidiaries, Frandisco Life Insurance Company and Frandisco Property and Casualty Insurance Company, reinsure the insurance coverage on our customers written on behalf of this non-affiliated insurance company.

The Company's operations are subject to various state and federal laws and regulations. We believe our operations are in compliance with applicable state and federal laws and regulations.

Financial Condition:

Total assets increased $19.3 million (5%) to $441.3 million at June 30, 2011 compared to $422.1 million at December 31, 2010. The increase was primarily due to increases in the Company’s cash and investment portfolios. Cash and cash equivalents increased $2.3 million (7%) and investment securities increased $17.2 million (22%). Funds provided from our operating activities and financing activities were the primary factors contributing to the increases. Management believes the current level of cash and cash equivalents, available borrowings under the Company’s credit facility and cash expected to be generated from operations will be sufficient to meet the Company’s present and foreseeable future liquidity needs.

At June 30, 2011, our loan portfolio, net of the allowance for loan losses, totaled $293.8 million compared to $295.0 at December 31, 2010. Historically, the Company has experienced lower levels of loan originations during the first quarter of each year. As the year progresses, loan originations grow and typically peak during the fourth quarter of each year. The Company experienced a growth in loan originations during the second quarter, offsetting a portion of the decline in the first quarter. At July 31, 2011, the Company posted a slight increase in the net loan portfolio compared to the December 31, 2010. Included in our net loan portfolio is our allowance for loan losses which reflects Management’s estimate of the level of allowance adequate to cover probable losses inherent in our loan portfolio as of the date of the statement of financial position. To evaluate the overall adequacy of our allowance for loan losses, we consider the level of loan receivables, historical loss trends, loan delinquency trends, bankruptcy trends and overall economic conditions. As a result of recent improvements in certain of these trends, Management reduced the allowance for loan losses to $23.4 million at June 30, 2011 compared to $24.1 million at December 31, 2010. See Note 2, “Allowance for Loan Losses,” in the accompanying “Notes to Unaudited Condensed Consolidated Financial Statements” for further discussion of the Company’s Allowance for Loan Losses. Management believes the allowance for loan losses was adequate to cover probable losses inherent in the portfolio at both dates; however, unexpected changes in trends or deterioration in economic conditions could result in a re-evaluation, and possibly a change in the allowance. Any increase could have a material adverse impact on our results of operations or financial condition in the future.

As previously mentioned, our investment portfolio increased $17.2 million (22%) at June 30, 2011 compared to the prior year end. The Company's investment portfolio consists mainly of U.S. Treasury bonds, government agency bonds and various municipal bonds. A portion of these investment securities have been designated as “available for sale” (60% as of June 30, 2011 and 85% as of December 31, 2010) with any unrealized gain or loss, net of deferred income taxes, accounted for as accumulated other comprehensive income in the equity section of the Company’s Consolidated Statement of Financial Position. The remainder of the Company’s investment portfolio represents securities carried at amortized cost and designated as “held to maturity,” as Management does not intend to sell, and does not believe that it is more likely than not that it would be required to sell, such securities before recovery of the amortized cost basis.

Net fixed assets grew approximately $.9 million during the six-month period ended June 30, 2011 mainly due to the replacement of obsolete computer equipment. The growth in fixed assets was the main cause of the $.7 million (5%) increase in other assets at June 30, 2011 compared to December 31, 2010.

As discussed previously, increased financing activities contributed to the increase in the Company’s liquidity position. The aggregate amount of senior and subordinated debt outstanding at June 30, 2011 was $282.7 million compared to $268.3 million at December 31, 2010. Higher sales of senior debt securities was the primary reason for the increase. A portion of the funds generated from the sales was used to repay the $.9 million outstanding balance under the Company’s revolving credit facility that was outstanding at December 31, 2010.

Disbursement of the 2010 incentive bonus during February 2011 was the primary reason for the $4.8 million (23%) decline in accrued expenses and other liabilities at June 30, 2011 compared to the prior year end.

Results of Operations:

During the first half of 2011, results of operations were ahead of Management’s original projections. Total revenues increased approximately $5.8 million (8%) to $76.3 million during the six-month period just ended compared to $70.5 million during the same period a year ago. Net income earned increased $4.6 million (47%) during the same period.

During the three-month period just ended, total revenues were $38.3 million compared to $35.1 million during the same three-month period in 2010. Net income increased $1.4 million (24%) during the same period.

Higher net interest income attributed to the increase in revenues during both the 2011 periods. The increase in revenues, lower credit losses and only marginal increases in expenses were the primary causes of the growth in net income in the same periods.

Net Interest Income

The Company’s net interest income (the difference between income on earning assets (loans and investments) and the cost of funds on interest bearing liabilities) was $24.1 million and $21.8 million for the three-month periods ended June 30, 2011 and 2010, respectively. During the six-month comparable periods, net interest income was $48.5 million and $44.0 million, respectively. The increase in net interest income was primarily due to additional interest and finance charges earned on a higher level of average net receivables outstanding. Average net receivables outstanding were $18.0 million higher during the first half of 2011 compared to the same period in 2010.

Lower borrowing costs also contributed to the aforementioned increase in our net interest income. Although average borrowings increased $20.4 million during the six-month period ended June 30, 2011 compared to the same period in 2010, the lower interest rate environment resulted in reduced interest expense. Weighted average borrowing rates on the Company’s debt decreased to 4.24% during the six-month period just ended compared to 4.96% during the same period a year ago. This decrease in average borrowing rates led to the $.5 million (8%) decrease in interest expense during the six-month comparable periods. During the three-month period just ended, interest expense decreased $.2 million or 5% as compared to the same period a year ago.

Management projects that, based on historical results, average net receivables will continue to grow through the remainder of the year, and earnings are expected to increase accordingly. However, a decrease in net receivables, or an increase in interest rates or outstanding borrowings could negatively impact our net interest margin.

Insurance Income

The Company’s net insurance income increased $.5 million (7%) and $1.0 million (7%) during the three- and six-month periods ended June 30, 2011 compared to the same periods ended June 30, 2010. Higher levels of insurance in-force led to the increases in net insurance income. As average net receivables increase, the Company typically sees an increase in levels of insurance in-force as more loan customers opt for insurance coverage with their loan.

Provision for Loan Losses

Our provision for loan losses was $3.5 million and $8.1 million for the three- and six-month periods ended June 30, 2011 compared to $4.7 million and $10.3 million, respectively, for the same periods in 2010. The decrease in the provision for losses is a result of lower net charge offs and a reduction in our overall allowance for loan losses. Net charge offs were $4.3 million and $8.9 million for the three- and six-month periods ended June 30, 2011 compared to $4.7 million and $10.3 million for the same comparable periods a year ago, respectively.

Determining a proper allowance for loan losses is a critical accounting estimate which involves Management’s judgment with respect to certain relevant factors, such as historical and expected loss trends, unemployment rates in various locales, current and expected net charge offs, delinquency levels, bankruptcy trends and overall general economic conditions. As a result of favorable trends in many of these factors during the current year, Management reduced the allowance for loan losses $750,000 at June 30, 2011 compared to December 31, 2010.

Management continues to monitor unemployment rates, which have improved slightly, but remain higher than historical averages in the states in which we operate. Rising gasoline prices are also being monitored. These factors tend to adversely impact our customers which, in turn, could have an adverse impact on our allowance for loan losses. Based on present and expected overall economic conditions, however, Management believes the allowance for loan losses is adequate to absorb inherent losses in the loan portfolio as of June 30, 2011. However continued high levels of unemployment and/or volatile market conditions could cause actual losses to vary from our estimated amounts. Management may determine it is appropriate to increase the allowance for loan losses in future periods, or actual losses could exceed allowances in any period, either of which could have a material negative impact on our results of operations in the future.

Other Operating Expenses

Total personnel expense increased $1.6 million and $2.1 million, or 13% and 8%, respectively, during the three- and six-month periods ended June 30, 2011 compared to the same periods in 2010. The increase was mainly due to higher salary expense, increases in the accrual for the employee incentive bonus plan and increases in medical claim expenses associated with the Company’s self-insured employee medical program in the 2011 periods when compared to the 2010 periods.

Occupancy expense for the three- and six-month periods ended June 30, 2011 was $.2 million (7%) and $.3 million (5%) higher than the same comparable periods a year ago. Higher costs associated with maintenance expenses on office and equipment, communication expenses, utility expenses and rent expense contributed to the increase in occupancy expense during the current year. The replacement of certain computer equipment during the second quarter of 2011 also contributed to the increase in occupancy expense for that period.

Miscellaneous other operating expenses increased $1.1 million (24%) and $1.2 million (13%) during the three- and six-month periods ended June 30, 2011 compared to the same periods during 2010. The increase in miscellaneous other operating expenses during the current year correlates with higher expenses related to advertising, technology, security sales, office supplies, postage, training and taxes as compared to the 2010 periods.

Income Taxes

The Company has elected to be, and is, treated as an S corporation for income tax reporting purposes. Taxable income or loss of an S corporation is passed through to, and included in the individual tax returns of, the shareholders of the Company, rather then being taxed at the corporate level. Notwithstanding this election, however, income taxes continue to be reported for, and paid by, the Company's insurance subsidiaries as they are not allowed to be treated as S corporations, and for the Company’s state taxes in Louisiana, which does not recognize S Corporation status. Deferred income tax assets and liabilities are recognized and provisions for current and deferred income taxes continue to be recorded by the Company’s subsidiaries. The Company uses the liability method of accounting for deferred income taxes and provides deferred income taxes for all significant income tax temporary differences.

Effective income tax rates were 8% and 10% during the six-month periods ended June 30, 2011 and 2010, respectively. During the three-month periods ended June 30, 2011 and 2010, effective income tax rates were 8% and 9%, respectively. The lower tax rate experienced during the current year period was due to higher income at the S corporation level which was passed to the shareholders of the Company for tax reporting purposes, whereas income earned at the insurance subsidiary level was taxed at the corporate level.

Quantitative and Qualitative Disclosures About Market Risk:

Interest rates continued to be near historical low levels during the reporting period. We currently expect only minimal fluctuations in market interest rates during the remainder of the year, thereby minimizing the expected impact on our net interest margin; however, no assurances can be given in this regard. Please refer to the market risk analysis discussion contained in our annual report on Form 10-K as of and for the year ended December 31, 2010 for a more detailed analysis of our market risk exposure, which we do not believe has changed materially since such date.

Liquidity and Capital Resources:

As of June 30, 2011 and December 31, 2010, the Company had $33.0 million and $30.7 million, respectively, invested in cash and cash equivalents, the majority of which was held by the Company’s insurance subsidiaries.

The Company’s investments in marketable securities can be readily converted into cash, if necessary. State insurance regulations limit the use an insurance company can make of its assets. Dividend payments to a parent company by its wholly-owned insurance subsidiaries are subject to annual limitations and are restricted to the greater of 10% of policyholders’ surplus or statutory earnings before recognizing realized investment gains of the individual insurance subsidiaries. At December 31, 2010, Frandisco Property and Casualty Insurance Company (“Frandisco P&C”) and Frandisco Life Insurance Company (“Frandisco Life”), the Company’s wholly-owned insurance subsidiaries, had policyholders’ surpluses of $40.7 million and $41.4 million, respectively. The maximum aggregate amount of dividends these subsidiaries can pay to the Company in 2011, without prior approval of the Georgia Insurance Commissioner, is approximately $8.2 million. In May 2011, the Company filed a request with the Georgia Insurance Department for the insurance subsidiaries to be eligible to pay up to $45.0 million in additional extraordinary dividends during 2011. Management requested the approval to ensure the availability of additional liquidity in the event it was needed by the Company. In July 2011, the request was approved. No dividends have been paid during 2011.

The majority of the Company’s liquidity requirements are financed through the collection of receivables and through the sale of short- and long-term debt securities. The Company’s continued liquidity is therefore dependent on the collection of its receivables and the sale of debt securities that meet the investment requirements of the public. In addition to its receivables and securities sales, the Company has an external source of funds available under a credit facility with Wells Fargo Preferred Capital, Inc. (the “credit agreement”). As amended to date, the credit agreement provides for borrowings of up to $100.0 million, subject to certain limitations, and all borrowings are secured by the finance receivables of the Company. Available borrowings under the credit agreement were $100.0 million at June 30, 2011, at an interest rate of 3.75%. This compares to available borrowings of $99.1 million at December 31, 2010, at an interest rate of 3.75%. The credit agreement contains covenants customary for financing transactions of this type. At June 30, 2011, the Company was in compliance with all covenants. The agreement is scheduled to expire on September 11, 2013 and any amounts then outstanding will be due and payable on such date. Management believes this credit facility should provide sufficient liquidity for the continued growth of the Company for the foreseeable future.

The Company was subject to the following contractual obligations and commitments at June 30, 2011:

	Total	Less Than 1 Year	1 to 2 Years	3 to 5 Years	More Than 5 Years
	(In Millions)
Bank Commitment Fee *	$ .3	$ .6	$ .5	$ .4	$ -
Senior Notes *	43.3	43.3	-	-	-
Commercial Paper *	189.3	168.1	21.2	-	-
Subordinated Debt *	61.2	9.5	25.1	26.6	-
Human Resource Insurance & Support Contracts	1.1	.6	5	-	-
Operating Leases	13.1	2.3	7.3	3.5	-
Data Communication Lines Contract **	4.1	.7	3.4	-	-
Software Service Contract **	20.2	1.3	5.4	8.1	5.4
Total	$ 332.6	$ 226.4	$ 63.4	$ 38.6	$ 5.4

* Note: Includes estimated interest at current rates.
** Note: Based on current usage.

Critical Accounting Policies:

The accounting and reporting policies of the Company are in accordance with accounting principles generally accepted in the United States and conform to general practices within the financial services industry. The Company’s critical accounting and reporting policies include the allowance for loan losses, revenue recognition and insurance claims reserves.

Allowance for Loan Losses

Provisions for loan losses are charged to operations in amounts sufficient to maintain the allowance for loan losses at a level considered adequate to cover probable credit losses inherent in our loan portfolio.

The allowance for loan losses is established based on the determination of the amount of probable losses inherent in the loan portfolio as of the reporting date. We review, among other things, historical charge off experience factors, delinquency reports, historical collection rates, economic trends such as unemployment rates, gasoline prices and bankruptcy filings and other information in order to make what we believe are the necessary judgments as to probable losses. Assumptions regarding probable losses are reviewed periodically and may be impacted by our actual loss experience and changes in any of the factors discussed above.

Revenue Recognition

Accounting principles generally accepted in the United States require that an interest yield method be used to calculate the income recognized on accounts which have precomputed charges. An interest yield method is used by the Company on each individual account with precomputed charges to calculate income for those active accounts; however, state regulations often allow interest refunds to be made according to the Rule of 78’s method for payoffs and renewals. Since the majority of the Company's accounts with precomputed charges are paid off or renewed prior to maturity, the result is that most of those accounts effectively yield on a Rule of 78's basis.

Precomputed finance charges are included in the gross amount of certain direct cash loans, sales finance contracts and certain real estate loans. These precomputed charges are deferred and recognized as income on an accrual basis using the effective interest method. Some other cash loans and real estate loans, which do not have precomputed charges, have income recognized on a simple interest accrual basis. Income is not accrued on any loan that is more than 60 days past due.

Loan fees and origination costs are deferred and recognized as adjustments to the loan yield over the contractual life of the related loan.

The property and casualty credit insurance policies written by the Company, as agent for a non-affiliated insurance company, are reinsured by the Company’s property and casualty insurance subsidiary. The premiums on these policies are deferred and earned over the period of insurance coverage using the pro-rata method or the effective yield method, depending on whether the amount of insurance coverage generally remains level or declines.

The credit life and accident and health insurance policies written by the Company, as agent for a non-affiliated insurance company, are reinsured by the Company’s life insurance subsidiary. The premiums are deferred and earned using the pro-rata method for level-term life insurance policies and the effective yield method for decreasing-term life policies. Premiums on accident and health insurance policies are earned based on an average of the pro-rata method and the effective yield method.

Insurance Claims Reserves

Included in unearned insurance premiums and commissions on the consolidated statements of financial position are reserves for incurred but unpaid credit insurance claims for policies written by the Company and reinsured by the Company’s wholly-owned insurance subsidiaries. These reserves are established based on generally accepted actuarial methods. In the event that the Company’s actual reported losses for any given period are materially in excess of the previously estimated amounts, such losses could have a material adverse effect on the Company’s results of operations.

Different assumptions in the application of any of these policies could result in material changes in the Company’s consolidated financial position or consolidated results of operations.

Recent Accounting Pronouncements:

See Note 1, “Recent Accounting Pronouncements,” in the accompanying “Notes to Unaudited Condensed Consolidated Financial Statements” for a discussion of new accounting standards and the expected impact of accounting standards recently issued but not yet required to be adopted. For pronouncements already adopted, any material impacts on the Company’s consolidated financial statements are discussed in the applicable section(s) of this Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the accompanying Notes to Unaudited Condensed Consolidated Financial Statements.