UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended June 30, 2012

OR

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

Commission File Number 0-18832

First Financial Service Corporation

(Exact Name of Registrant as specified in its charter)

Kentucky	61-1168311
(State or other jurisdiction	(IRS Employer Identification No.)
of incorporation or organization)
2323 Ring Road	(270) 765-2131
Elizabethtown, Kentucky 42701	(Registrant’s telephone number,
(Address of principal executive offices)	including area code)
(Zip Code)

(270) 765-2131

(Registrant’s telephone number, including area code)

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.

Large Accelerated Filer ¨ Accelerated Filer ¨ Non-Accelerated Filer ¨ Smaller Reporting Company x

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

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

Class	Outstanding as of July 31, 2012
Common Stock	4,772,649 shares

FIRST FINANCIAL SERVICE CORPORATION

FORM 10-Q

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION
Preliminary Note Regarding Forward-Looking Statements
Item 1.	Consolidated Financial Statements and Notes to Consolidated Financial Statements	4
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	42
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	62
Item 4.	Controls and Procedures	64
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	64
Item 1A.	Risk Factors	64
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	64
Item 3.	Defaults upon Senior Securities	65
Item 4.	Mine Safety Disclosures	65
Item 5.	Other Information	65
Item 6.	Exhibits	65
SIGNATURES		66

2

PRELIMINARY NOTE REGARDING

FORWARD-LOOKING STATEMENTS

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

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

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

3

Item 1.

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Balance Sheets

(Unaudited)

	June 30,			December 31,
(Dollars in thousands, except per share data)	2012			2011
ASSETS:
Cash and due from banks	$	15,331		$	12,973
Interest bearing deposits		138,783			79,263
Total cash and cash equivalents		154,114			92,236
Securities available-for-sale		317,288			313,777
Securities held-to-maturity, fair value of $16 Jun (2012) and $24 Dec (2011)		16			24
Total securities		317,304			313,801
Loans held for sale		103,593			56,016
Loans, net of unearned fees		536,166			691,253
Allowance for loan losses		(15,300	)		(17,181	)
Net loans		520,866			674,072
Federal Home Loan Bank stock		4,805			4,805
Cash surrender value of life insurance		9,880			9,702
Premises and equipment, net		21,931			29,694
Premises and equipment held for sale,net		6,771			946
Real estate owned:
Acquired through foreclosure		36,529			29,083
Held for development		-			45
Other repossessed assets		30			42
Core deposit intangible		587			714
Accrued interest receivable		2,466			3,168
Accrued income taxes		2,948			3,517
Prepaid FDIC Insurance		247			1,302
Low-income housing investments		7,512			7,671
Other assets		2,105			1,964
TOTAL ASSETS	$	1,191,688		$	1,228,778
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES:
Deposits:
Non-interest bearing	$	69,199		$	72,675
Non-interest bearing held for sale		13,397			4,954
Interest bearing		694,502			932,915
Interest bearing held for sale		312,204			112,250
Total deposits		1,089,302			1,122,794
Advances from Federal Home Loan Bank		27,666			27,736
Subordinated debentures		18,000			18,000
Accrued interest payable		2,499			1,817
Accounts payable and other liabilities		5,735			4,968
TOTAL LIABILITIES		1,143,202			1,175,315
Commitments and contingent liabilities		-			-
STOCKHOLDERS’ EQUITY:
Serial preferred stock, $1 par value per share; authorized 5,000,000 shares; issued and outstanding, 20,000 shares with a liquidation preference of $20,000		19,916			19,889
Common stock, $1 par value per share; authorized 35,000,000 shares; issued and outstanding, 4,772,649 shares Jun (2012), and 4,749,415 shares Dec (2011)		4,773			4,749
Additional paid-in capital		35,561			35,450
Retained earnings/(accumulated deficit)		(12,907	)		(7,951	)
Accumulated other comprehensive income		1,143			1,326
TOTAL STOCKHOLDERS’ EQUITY		48,486			53,463
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	1,191,688		$	1,228,778

See notes to the unaudited consolidated financial statements.

4

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Operations

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
(Dollars in thousands, except per share data)	2012			2011			2012			2011
Interest and Dividend Income:
Loans, including fees	$	8,868		$	11,692		$	18,829		$	24,035
Taxable securities		1,726			1,703			3,436			3,269
Tax exempt securities		144			265			357			522
Total interest income		10,738			13,660			22,622			27,826
Interest Expense:
Deposits		3,444			4,674			7,389			9,588
Federal Home Loan Bank advances		283			280			567			575
Subordinated debentures		341			350			682			691
Total interest expense		4,068			5,304			8,638			10,854
Net interest income		6,670			8,356			13,984			16,972
Provision for loan losses		915			9,517			1,927			12,982
Net interest income after provision for loan losses		5,755			(1,161	)		12,057			3,990
Non-interest Income:
Customer service fees on deposit accounts		1,399			1,554			2,782			2,999
Gain on sale of mortgage loans		384			291			695			556
Gain on sale of investments		598			162			1,309			231
Loss on sale of investments		(303	)		(38	)		(303	)		(38	)
Other than temporary impairment loss:
Total other-than-temporary impairment losses		-			(67	)		(26	)		(104	)
Portion of loss recognized in other comprehensive income/(loss) (before taxes)		-			-			-			-
Net impairment losses recognized in earnings		-			(67	)		(26	)		(104	)
Loss on sale and write downs on real estate acquired through foreclosure		(2,016	)		(4,651	)		(3,582	)		(4,886	)
Gain on sale of premises and equipment		322			-			322			-
Gain on sale on real estate acquired through foreclosure		210			96			613			121
Gain on sale on real estate held for development		-			-			175			-
Brokerage commissions		112			108			207			215
Other income		617			380			1,028			734
Total non-interest income		1,323			(2,165	)		3,220			(172	)
Non-interest Expense:
Employee compensation and benefits		3,822			3,958			7,675			8,287
Office occupancy expense and equipment		782			832			1,550			1,643
Marketing and advertising		135			164			168			389
Outside services and data processing		893			1,056			1,704			1,853
Bank franchise tax		402			342			744			656
FDIC insurance premiums		682			906			1,097			1,876
Amortization of core deposit intangible		62			76			127			153
Real estate acquired through foreclosure expense		2,336			646			2,676			1,028
Loan expense		656			557			1,164			609
Other expense		1,446			1,379			2,800			2,828
Total non-interest expense		11,216			9,916			19,705			19,322
Income/(loss) before income taxes		(4,138	)		(13,242	)		(4,428	)		(15,504	)
Income taxes/(benefits)		1			(1,338	)		1			(1,530	)
Net Income/(Loss)		(4,139	)		(11,904	)		(4,429	)		(13,974	)
Less:
Dividends on preferred stock		(250	)		(250	)		(500	)		(500	)
Accretion on preferred stock		(13	)		(13	)		(27	)		(27	)
Net income (loss) attributable to common shareholders	$	(4,402	)	$	(12,167	)	$	(4,956	)	$	(14,501	)
Shares applicable to basic income per common share		4,767,464			4,739,700			4,764,240			4,737,761
Basic income (loss) per common share	$	(0.92	)	$	(2.57	)	$	(1.04	)	$	(3.06	)
Shares applicable to diluted income per common share		4,767,464			4,739,700			4,764,240			4,737,761
Diluted income (loss) per common share	$	(0.92	)	$	(2.57	)	$	(1.04	)	$	(3.06	)
Cash dividends declared per common share	$	-		$	-		$	-		$	-

See notes to the unaudited consolidated financial statements.

5

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Comprehensive Income/(Loss)

(Unaudited)

	Three Months Ended						Six Months Ended
	June 30,						June 30,
(Dollars in thousands)	2012			2011			2012			2011
Net Income/(Loss)	$	(4,139	)	$	(11,904	)	$	(4,429	)	$	(13,974	)
Other comprehensive income (loss):
Change in unrealized gain (loss) on securities available-for-sale		152			4,716			768			5,923
Change in unrealized gain (loss) on securities available-for-sale for which a portion of other-than-temporary impairment has been recognized into earnings		(15	)		(100	)		(21	)		293
Reclassification of realized amount on securities available-for-sale losses (gains)		(295	)		(124	)		(1,006	)		(168	)
Reclassification of unrealized loss on held-to-maturity security recognized in income		-			67			26			79
Accretion (amortization) of non-credit component of other-than-temporary impairment on held-to-maturity securities		50			-			50			(1	)
Net unrealized gain (loss) recognized in comprehensive income		(108	)		4,559			(183	)		6,126
Tax effect		-			(1,550	)		-			(2,083	)
Total other comphrehensive income/(loss)		(108	)		3,009			(183	)		4,043
Comprehensive Income/(Loss)	$	(4,247	)	$	(8,895	)	$	(4,612	)	$	(9,931	)

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

	Balance			Current			Balance
	at			Period			at
	12/31/2011			Change			6/30/2012
Unrealized gains (losses) on securities available-for-sale	$	139		$	(219	)	$	(80	)
Unrealized gains (losses) on available-for-sale  securities for which OTTI has been recorded,		1,237			(14	)		1,223
Unrealized gains (losses) on held-to-maturity securities for which OTTI has been recorded, net of accretion		(50	)		50			-
Total	$	1,326		$	(183	)	$	1,143

See notes to the unaudited consolidated financial statements.

6

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Changes in Stockholders’ Equity

Six Months Ended June 30, 2012

(Dollars In Thousands, Except Per Share Amounts

(Unaudited)

	Shares				Amount				Additional Paid-in		Retained Earnings/ (Accumulated			Accumulated Other Comprehensive Income, Net of
	Preferred		Common		Preferred		Common		Capital		Deficit)			Tax			Total
Balance, January 1, 2012		20,000		4,749,415	$	19,889	$	4,749	$	35,450	$	(7,951	)	$	1,326		$	53,463
Net income/(loss)												(4,429	)					(4,429	)
Shares issued under dividend reinvestment program				1,599				2		2								4
Stock issued for employee benefit plans				21,635				22		17								39
Stock-based compensation expense										92								92
Net change in unrealized gains (losses) on securities available-for-sale,															(219	)		(219	)
Change in unrealized gains (losses) on held-to-maturity securities for which an other-than-temporary impairment charge has been recorded															50			50
Change in unrealized gains (losses) on securities available-for-sale for which a portion of an other-than-temporary impairment charge has been recognized into earnings, net of reclassification															(14	)		(14	)
Dividends on preferred stock												(500	)					(500	)
Accretion of preferred stock discount		-		-		27		-		-		(27	)		-			-
Balance, June 30, 2012		20,000		4,772,649	$	19,916	$	4,773	$	35,561	$	(12,907	)	$	1,143		$	48,486

See notes to the unaudited consolidated financial statements.

7

FIRST FINANCIAL SERVICE CORPORATION

Consolidated Statements of Cash Flows

(Dollars In Thousands)

(Unaudited)

	Six Months Ended
	June 30,
	2012			2011
Operating Activities:
Net income/(loss)	$	(4,429	)	$	(13,974	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Provision for loan losses		1,927			12,982
Depreciation on premises and equipment		771			862
Core deposit intangible amortization		127			153
Loss on low-income housing investments		183			-
Net amortization (accretion) on securities available-for-sale		(904	)		(2,873	)
Impairment loss on securities available-for-sale		-			25
Impairment loss on securities held-to-maturity		26			79
Gain on sale of investments available-for-sale		(1,309	)		(231	)
Loss on sale of investments available-for-sale		303			35
Loss on sale of investments held-to-maturity		-			3
Gain on sale of mortgage loans		(695	)		(556	)
Gain on sale of premises and equipment		(322	)		-
Gain on sale of real estate acquired through foreclosure		(613	)		(121	)
Gain on sale of real estate held for development		(175	)		-
Write-downs on real estate acquired through foreclosure		3,543			4,649
Origination of loans held for sale		(27,572	)		(34,232	)
Proceeds on sale of loans held for sale		35,289			35,468
Stock-based compensation expense		92			95
Prepaid FDIC premium		1,055			1,806
Changes in:
Cash surrender value of life insurance		(178	)		(171	)
Interest receivable		702			(1,545	)
Other assets		1,040			170
Interest payable		682			576
Accounts payable and other liabilities		267			309
Net cash from operating activities		9,810			3,509
Investing Activities:
Sales of securities available-for-sale		87,454			88,197
Sales of securities held-to-maturity		-			92
Purchases of securities available-for-sale		(140,232	)		(180,139	)
Maturities of securities available-for-sale		50,919			15,500
Maturities of securities held-to-maturity		58			7
Net change in loans		70,654			57,119
Sale of portfolio loans		10,693			-
Redemption of Federal Home Loan Bank stock		-			104
Investment in low-income housing projects		(24	)		(5,724	)
Net purchases of premises and equipment		(86	)		(292	)
Sales of premises and equipment		1,575			-
Sales of real estate acquired through foreclosure		4,356			2,036
Sales of real estate held for development		220			-
Net cash from investing activities		85,587			(23,100	)
Financing Activities
Net change in deposits		(33,492	)		(46,726	)
Advance from Federal Home Loan Bank		-			337
Maturity of Federal Home Loan Bank advance		-			(25,000	)
Repayments to Federal Home Loan Bank		(70	)		(64	)
Issuance of common stock under dividend reinvestment program		4			2
Issuance of common stock for employee benefit plans		39			54
Net cash from financing activities		(33,519	)		(71,397	)
Increase (Decrease) in cash and cash equivalents		61,878			(90,988	)
Cash and cash equivalents, beginning of period		92,236			166,176
Cash and cash equivalents, end of period	$	154,114		$	75,188
Supplemental noncash disclosures:
Transfers from loans to real estate acquired through foreclosure and repossessed assets	$	15,541		$	9,438
Loans to facilitate sales of real estate owned and repossessed assets	$	208		$	2,101
Dividends accrued not paid on preferred stock	$	500		$	500
Transfers from loans to loans held for sale in probable branch divestiture	$	65,242		$	-

See notes to the unaudited consolidated financial statements.

8

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

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

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six month periods ending June 30, 2012 are not necessarily indicative of the results that may occur for the year ending December 31, 2012. For further information, refer to the consolidated financial statements and footnotes thereto included in the Corporation’s annual report on Form 10-K for the period ended December 31, 2011.

Reclassifications – Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year operations or shareholder’s equity.

9

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

2.            REGULATORY MATTERS

In its 2012 Consent Order with the FDIC and KDFI, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. At June 30, 2012, we were not in compliance with the Tier 1 and total risk-based capital requirements. We notified the bank regulatory agencies that the increased capital levels would not be achieved and anticipate that the FDIC and KDFI will reevaluate our progress toward achieving the higher capital ratios at September 30, 2012.

The 2012 Consent Order requires that if the Bank should be unable to reach the required capital levels by June 30, 2012, and the Bank receives written directions from the FDIC and KDFI to do so, then the Bank would develop, adopt and implement within 30 days a written plan to sell or merge itself into another federally insured financial institution. The 2012 Consent Order requires the Bank to continue to adhere to the plans implemented in response to the 2011 Consent Order, and includes the substantive provisions of the 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.

While the Bank did not meet the mandated capital ratios by June 30, 2012, we have not received any written communications from the FDIC or KDFI directing the Bank to develop, adopt and implement within 30 days a written plan to sell or merge itself into another federally insured financial institution.

The Bank’s Consent Orders with the FDIC and KDFI require us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends to the Corporation. The Bank is also no longer allowed to accept, renew or rollover brokered deposits, including deposits through the Certificate of Deposit Account Registry Service (CDARs) without first obtaining a written waiver from our regulators.

On April 20, 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends. We also may not redeem shares or obtain additional borrowings without prior approval.

Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business.

In response to the 2011 Consent Order, we engaged an investment banking firm with expertise in the financial services sector to assist with a review of all of our strategic alternatives as we work to achieve the higher regulatory capital ratios.

One of these strategic alternatives involved the sale of eight branches located outside of our core market. Effective after the close of business on July 6, 2012, we have successfully executed the sale of four banking centers located in Corydon, Elizabeth, Lanesville and Georgetown, Indiana to First Savings Bank, F.S.B. We received a 3.65% percent premium on the $102.3 million of consumer and commercial deposits at closing. They assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received zero premium or discount. We also sold approximately $30.4 million in performing loans at a discount of 0.80%. The consummated transaction resulted in a one-time gain of approximately $2.9 million.

We entered into a Branch Purchase Agreement with First Security Bank of Owensboro, Inc., the banking subsidiary of First Security, Inc., headquartered in Owensboro, Kentucky on May 15, 2012. The agreement provides for the sale of our four banking centers in Louisville, Kentucky to First Security. Under the terms of the Agreement, First Security will assume approximately $210.2 million of deposit liabilities. First Security will pay a deposit premium of approximately $2.9 million comprised of a premium of 2.00% on approximately $153.2 million of deposits and a premium ranging from 0% to 1.00% on approximately $57.0 million of other deposits. First Security will also assume performing loans related to the four branches at a 1.00% discount. The loans being assumed totaled approximately $70.9 million at June 30, 2012. The sale is expected to be completed in the third quarter of 2012 subject to First Security raising additional capital, regulatory approval and other customary closing conditions.

The divestiture of our Indiana franchise, combined with the impending sale of our four Louisville banking centers, is projected to increase our Tier I capital ratio from 5.73% to over 8.50% and increase our total risk-based capital ratio from 10.68% to over 12.00% based on June 30, 2012 financial information. The sale of our four Louisville banking centers is expected to close late in the third quarter of 2012.

10

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

2.             REGULATORY MATTERS – (Continued)

Additionally, we continue reducing our non-interest costs where possible to offset the increased credit costs associated with other real estate and non-performing loans while taking into consideration the resources necessary to execute our strategies. We have suspended the annual employee stock ownership contribution, frozen most executive management compensation the past three years and into 2012, frozen most officer compensation for the past year and into 2012, eliminated board of director fees, reduced marketing expenses, community donation expenses, compensation expense through reductions in associates, and implemented various other cost savings initiatives. Expense reductions for 2011 were $1.1 million and were approximately $600,000 for the 2012 six month period. We are also in the process of evaluating the remaining terms on existing contracts in an effort to identify expenses that can be eliminated in the near future. These efforts will remain ongoing.

On February 10, 2012, we announced several changes to our management and the board of directors. In addition, on May 15, 2012 we announced the appointment of Frank Perez as Chief Financial Officer of the Corporation and the Bank with responsibility for the overall financial functions. Mr. Perez has over fifteen years of experience in the banking industry as well as experience with publicly traded institutions, capital markets, and working with a troubled institution.

Our plans for 2012 include the following:

· Continuing to research and evaluate all available strategic options to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank. Strategic alternatives include divesting of branch offices, as noted earlier we have already sold four banking centers in the Indiana market and have a Branch Purchase Agreement to sell our four banking centers in the Louisville market. Selling loans as an additional measure to reduce our asset size and as a result improving our regulatory capital ratios. We have sold commercial real estate loans totaling $10.7 million, at par, to First Capital Bank of Kentucky during the first half of 2012.

· Continuing to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise. The strength of this franchise contributes to earnings to help withstand our credit quality issues. In addition, the inherent value of the retail franchise will provide value to the Bank to accomplish the various capital initiatives. As of June 30, 2011 data, we rank in the top three in four of the five counties that we serve. This excludes the Indiana market where we no longer have a presence and the Louisville market in anticipation of the pending sale of those branch centers in September. We rank first in Hardin County and Meade County with market share of approximately 26% and 51%, respectively.

· Continuing to reduce our lending concentration in commercial real estate through natural roll off and we have loan diversification initiatives in place that should improve the Bank’s loan portfolio. The mortgage and consumer lending operations continue to maintain strong credit quality metrics throughout the economic downturn. The diversification of the loan portfolio includes an increased emphasis on retail lending, small business lending, and Small Business Administration (“SBA”) lending which should provide a boost to non-interest fee income. We have already allocated and reallocated resources that should contribute to the successful execution of all of these efforts.

· We have enhanced the resources dedicated to special asset dispositions both on a permanent and temporary basis. This is a necessary step as we increase our ongoing efforts to speed up the disposal of our problem assets. This will significantly reduce the involvement of our commercial lenders in the special asset area allowing them to shift their focus to their existing loan customer base and to generate new business that will support our diversification efforts while stemming off some of the loan roll off. The new lenders that have been hired this year bring a significant amount of experience in real estate and commercial and industrial lending.

· We have added an experienced asset liability management consultant as an additional resource to support our efforts as we restructure the balance sheet, minimize our interest rate risk, and improve the net interest margin.

· Subsequent to the quarter ending June 30, 2012, we entered into sales contracts on nine other real estate owned properties totaling $20.5 million set to close during the third quarter of 2012, indicating a continued interest in our other real estate owned properties.  One of these sales consists of a bulk sale of fourteen properties which we are carrying at a value of $16.2 million.  The net proceeds after sales expenses will be $15.1 million, resulting  in a $1.1 million charge against these properties for the quarter ending June 30, 2012.  We incurred higher than usual commission and closing costs due to the size of the transaction.  If sold on an individual basis, it is unlikely that we would have taken this type of charge against these properties.  However, if this transaction goes through under these terms, it would represent a 56% decrease to our other real estate owned properties balance of $36.5 million as of June 30, 2012.

11

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3. SECURITIES

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

			Gross		Gross
	Amortized		Unrealized		Unrealized
(Dollars in thousands)	Cost		Gains		Losses			Fair Value
Securities available-for-sale:
June 30, 2012:
U.S. Treasury and agencies	$	12,994	$	32	$	-		$	13,026
Government-sponsored mortgage-backed residential		278,751		3,498		(401	)		281,848
State and municipal		12,575		1,391		-			13,966
Corporate bonds		8,196		-		(14	)		8,182
Trust preferred securities		1,071		-		(805	)		266
Total	$	313,587	$	4,921	$	(1,220	)	$	317,288
December 31, 2011:
U.S. Treasury and agencies	$	24,993	$	35	$	-		$	25,028
Government-sponsored mortgage-backed residential		261,506		3,389		(204	)		264,691
State and municipal		22,270		1,524		-			23,794
Trust preferred securities		1,048		-		(784	)		264
Total	$	309,817	$	4,948	$	(988	)	$	313,777

			Gross		Gross
	Amortized		Unrecognized		Unrecognized
	Cost		Gains		Losses		Fair Value
Securities held-to-maturity:
June 30, 2012:
Trust preferred securities	$	16	$	-	$	-	$	16
Total	$	16	$	-		-	$	16
December 31, 2011:
Trust preferred securities	$	24	$	-	$	-	$	24
Total	$	24	$	-		-	$	24

12

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3. SECURITIES – (Continued)

The amortized cost and fair value of securities at June 30, 2012, by contractual maturity, are shown below. Securities not due at a single maturity date, primarily mortgage-backed securities, are shown separately.

	Available for Sale				Held-to-Maturity
	Amortized		Fair		Amortized		Fair
(Dollars in thousands)	Cost		Value		Cost		Value
Due after one year through five years	$	8,196	$	8,182	$	-	$	-
Due after ten years		26,640		27,258		16		16
Government-sponsored mortgage-backed residential		278,751		281,848		-		-
	$	313,587	$	317,288	$	16	$	16

The following schedule shows the proceeds from sales of available-for-sale securities and the gross realized gains and losses on those sales:

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
(Dollars in thousands)
Proceeds from sales	$	57,733	$	72,018	$	87,454	$	88,289
Gross realized gains		598		162		1,309		231
Gross realized losses		303		38		303		38

Investment securities pledged to secure public deposits and FHLB advances had an amortized cost of $131.9 million and fair value of $134.3 million at June 30, 2012 and a $119.1 million amortized cost and fair value of $121.1 million at December 31, 2011.

Securities with unrealized losses at June 30, 2012 and December 31, 2011 aggregated by major security type and length of time in a continuous unrealized loss position are as follows:

June 30, 2012	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
Government-sponsored mortgage-backed residential	$	83,877	$	(401	)	$	-	$	-		$	83,877	$	(401	)
Corporate bonds		8,182		(14	)		-		-			8,182		(14	)
Trust preferred securities		-		-			266		(805	)		266		(805	)
Total temporarily impaired	$	92,059	$	(415	)	$	266	$	(805	)	$	92,325	$	(1,220	)

December 31, 2011	Less than 12 Months					12 Months or More					Total
	Fair		Unrealized			Fair		Unrealized			Fair		Unrealized
Description of Securities	Value		Loss			Value		Loss			Value		Loss
Government-sponsored mortgage-backed residential	$	43,911	$	(204	)	$	-	$	-		$	43,911	$	(204	)
Trust preferred securities		-		-			264		(784	)		264		(784	)
Total temporarily impaired	$	43,911	$	(204	)	$	264	$	(784	)	$	44,175	$	(988	)

13

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3. SECURITIES – (Continued)

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

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

The unrealized losses on our government sponsored mortgage-backed residential securities and corporate bonds were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at June 30, 2012.

As discussed in Note 9 - Fair Value, the fair value of our portfolio of trust preferred securities, is significantly below the amortized cost.  There is limited trading in trust preferred securities and the majority of holders of such instruments have elected not to participate in the market unless they are required to sell as a result of liquidation, bankruptcy, or other forced or distressed conditions.

To determine if the five trust preferred securities were other than temporarily impaired as of June 30, 2012, we used a discounted cash flow analysis.  The cash flow models were used to determine if the current present value of the cash flows expected on each security were still equivalent to the original cash flows projected on the security when purchased.   The cash flow analysis takes into consideration assumptions for prepayments, defaults and deferrals for the underlying pool of banks, insurance companies and REITs.

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

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

· We assume that annual defaults for the remaining life of each security will be between 37.5 and 100 basis points.

· We assume a recovery rate of 40% on PreTSL IV and 15% on the remaining trust preferred securities on deferrals after two years.

· We assume 1% prepayments through the five year par call and then 1% per annum to account for the potential prepayments of large banks under the new Dodd Frank legislation.

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

14

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

3. SECURITIES – (Continued)

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

· Valuation estimates provided by our investment broker;

· The amount of fair value decline;

· How long the decline in fair value has existed;

· Significant rating agency changes on the issuer;

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

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

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

· Other relevant observable inputs.

The following table details the five debt securities with other-than-temporary impairment at June 30, 2012 and the related credit losses recognized in earnings during the six months ended June 30, 2012:

		Moody’s										% of Current
		Credit	Current							Current		Deferrals and
(Dollars in thousands)		Ratings	Moody’s					Estimated		Deferrals		Defaults			Year to Date
		When	Credit	Par		Amortized		Fair		and		to Current			OTTI
Security	Tranche	Purchased	Ratings	Value		Cost		Value		Defaults		Collateral			Recognized
Preferred Term Securities IV	Mezzanine	A3	Ca	$	244	$	122	$	111	$	18,000		27	%	$	-
Preferred Term Securities VI	Mezzanine	A1	Ca		208		16		16		30,000		74	%		26
Preferred Term Securities XV B1	Mezzanine	A2	C		1,065		445		125		195,200		34	%		-
Preferred Term Securities XXI C2	Mezzanine	A3	C		1,156		415		30		209,890		29	%		-
Preferred Term Securities XXII C1	Mezzanine	A3	Ca		527		89		-		388,000		30	%		-
Total				$	3,200	$	1,087	$	282						$	26

Preferred Term Security VI was called for early redemption in July 2012. We received principal and interest of $209,000 and recorded a gain on sale of $192,000.

The table below presents a roll-forward of the credit losses recognized in earnings since the acquisition of the above trust preferred securities:

(Dollars in thousands)	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2012		2011		2012		2011
Beginning balance	$	2,104	$	1,947	$	2,078	$	1,910
Increases to the amount related to the credit loss for which other-than-temporary impairment was previously recognized		-		67		26		104
Ending balance	$	2,104	$	2,014	$	2,104	$	2,014

15

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS

Loans are summarized as follows:

	June 30,			December 31,
(Dollars in thousands)	2012			2011
Commercial	$	24,865		$	30,135
Commercial Real Estate:
Land Development		29,772			35,924
Building Lots		2,742			3,880
Other		349,301			418,981
Real estate construction		3,950			4,925
Residential mortgage		143,273			151,866
Consumer and home equity		64,197			69,971
Indirect consumer		19,500			21,892
		637,600			737,574
Less:
Loans held for sale in probable branch divestiture		(101,325	)		(46,112	)
Net deferred loan origination fees		(109	)		(209	)
Allowance for loan losses		(15,300	)		(17,181	)
		(116,734	)		(63,502	)
Net Loans	$	520,866		$	674,072

The following tables present the activity in the allowance for loan losses by portfolio segment for the quarter and six months ending June 30, 2012 and 2011:

Three Months Ended
June 30, 2012				Commercial			Real Estate			Residential			Consumer &			Indirect
	Commercial			Real Estate			Construction			Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,723		$	13,628		$	103		$	882		$	643		$	350		$	17,329
Provision for loan losses		(255	)		1,189			(14	)		(34	)		23			6			915
Allowance associated with probable branch divestitures		(25	)		(581	)		-			(14	)		(62	)		-			(682	)
Charge-offs		-			(2,191	)		-			(31	)		(102	)		(55	)		(2,379	)
Recoveries		40			35			-			-			23			19			117
Total ending allowance balance	$	1,483		$	12,080		$	89		$	803		$	525		$	320		$	15,300

Six Months Ended
June 30, 2012				Commercial			Real Estate			Residential			Consumer &			Indirect
	Commercial			Real Estate			Construction			Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,422		$	13,727		$	103		$	922		$	610		$	397		$	17,181
Provision for loan losses		222			1,687			(14	)		(52	)		98			(14	)		1,927
Allowance associated with probable branch divestitures		(25	)		(581	)		-			(6	)		(57	)		-			(669	)
Charge-offs		(187	)		(2,804	)		-			(62	)		(176	)		(99	)		(3,328	)
Recoveries		51			51			-			1			50			36			189
Total ending allowance balance	$	1,483		$	12,080		$	89		$	803		$	525		$	320		$	15,300

16

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

Three Months Ended
June 30, 2011				Commercial			Real Estate			Residential			Consumer &			Indirect
	Commercial			Real Estate			Construction			Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,679		$	20,536		$	104		$	776		$	742		$	754		$	24,591
Provision for loan losses		(225	)		9,655			-			131			(29	)		(15	)		9,517
Charge-offs		(100	)		(16,068	)		(9	)		(205	)		(38	)		(56	)		(16,476	)
Recoveries		17			10			-			-			15			34			76
Total ending allowance balance	$	1,371		$	14,133		$	95		$	702		$	690		$	717		$	17,708

Six Months Ended
June 30, 2011				Commercial			Real Estate			Residential			Consumer &			Indirect
	Commercial			Real Estate			Construction			Mortgage			Home Equity			Consumer			Total
(Dollars in thousands)
Allowance for loan losses:
Beginning Balance	$	1,657		$	18,595		$	158		$	751		$	708		$	796		$	22,665
Provision for loan losses		(203	)		13,006			-			174			55			(50	)		12,982
Charge-offs		(142	)		(17,684	)		(63	)		(224	)		(136	)		(87	)		(18,336	)
Recoveries		59			216			-			1			63			58			397
Total ending allowance balance	$	1,371		$	14,133		$	95		$	702		$	690		$	717		$	17,708

We did not implement any changes to our allowance related accounting policies or methodology during the current period.

The following table presents the balance in the allowance for loan losses and the recorded investment in loans by portfolio segment and based on the impairment method as of June 30, 2012 and 2011 and December 31, 2011:

June 30, 2012				Commercial			Real Estate		Residential			Consumer &			Indirect
	Commercial			Real Estate			Construction		Mortgage			Home Equity			Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	332		$	4,609			-	$	383		$	126		$	6	$	5,456
Collectively evaluated for impairment		1,151			7,471			89		420			399			314		9,844
Loans held for sale		-			-			-		-			-			-		-
Total ending allowance balance	$	1,483		$	12,080			89	$	803		$	525		$	320	$	15,300
Loans:
Loans individually evaluated for impairment	$	1,396		$	56,493		$	-	$	1,098		$	302		$	38	$	59,327
Loans collectively evaluated for impairment		23,469			325,322			3,950		142,175			63,895			19,462		578,273
Loans held for sale		(2,520	)		(58,767	)		-		(29,232	)		(10,806	)		-		(101,325	)
Total ending loans balance	$	22,345		$	323,048		$	3,950	$	114,041		$	53,391		$	19,500	$	536,275

December 31, 2011				Commercial			Real Estate		Residential			Consumer &			Indirect
	Commercial			Real Estate			Construction		Mortgage			Home Equity			Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	410		$	3,403			-	$	481		$	109		$	39	$	4,442
Collectively evaluated for impairment		1,012			10,324			103		441			501			358		12,739
Loans held for sale		-			-			-		-			-			-		-
Total ending allowance balance	$	1,422		$	13,727			103	$	922		$	610		$	397	$	17,181
Loans:
Loans individually evaluated for impairment	$	3,230		$	61,345		$	-	$	1,681		$	193		$	123	$	66,572
Loans collectively evaluated for impairment		26,905			397,440			4,925		150,185			69,778			21,769		671,002
Loans held for sale		(18	)		(11,411	)		-		(29,520	)		(5,163	)		-		(46,112	)
Total ending loans balance	$	30,117		$	447,374		$	4,925	$	122,346		$	64,808		$	21,892	$	691,462

17

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

June 30, 2011			Commercial		Real Estate		Residential		Consumer &		Indirect
	Commercial		Real Estate		Construction		Mortgage		Home Equity		Consumer		Total
(Dollars in thousands)
Allowance for loan losses:
Ending allowance balance attributable to loans:
Individually evaluated for impairment	$	566	$	6,796		-	$	220	$	130	$	33	$	7,745
Collectively evaluated for impairment		805		7,337		95		482		560		684		9,963
Total ending allowance balance	$	1,371	$	14,133		95	$	702	$	690	$	717	$	17,708
Loans:
Loans individually evaluated for impairment	$	4,102	$	78,005	$	998	$	1,311	$	247	$	176	$	84,839
Loans collectively evaluated for impairment		27,331		425,295		6,358		156,084		74,278		25,563		714,909
Total ending loans balance	$	31,433	$	503,300	$	7,356	$	157,395	$	74,525	$	25,739	$	799,748

The following table presents loans individually evaluated for impairment by class of loans as of June 30, 2012 and 2011 and December 31, 2011. The difference between the unpaid principal balance and recorded investment represents partial write downs/charge offs taken on individual impaired credits. The recorded investment and average recorded investment in loans excludes accrued interest receivable and loan origination fees.

							Three Months Ended						Six Months Ended
							June 30, 2012						June 30, 2012
June 30, 2012	Unpaid				Allowance for		Average		Interest		Cash Basis		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest		Recorded		Income		Interest
(Dollars in thousands)	Balance		Investment		Allocated		Investment		Recognized		Recognized		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	1,111	$	991	$	-	$	944	$	31	$	31	$	1,347	$	53	$	53
Commercial Real Estate:
Land Development		11,532		5,771		-		5,176		185		185		5,825		214		214
Building Lots		1,061		1,030		-		924		26		26		1,051		17		17
Other		32,183		28,726		-		30,254		1,120		1,120		30,948		1,173		1,173
Real Estate Construction		-		-		-		-		-		-		-		-		-
Residential Mortgage		-		-		-		-		-		-		-		-		-
Consumer and Home Equity		-		-		-		-		-		-		-		-		-
Indirect Consumer		-		-		-		-		-		-		-		-		-
With an allowance recorded:
Commercial		407		405		332		477		16		16		676		27		27
Commercial Real Estate:
Land Development		786		740		190		2,303		82		82		2,519		93		93
Building Lots		-		-		-		238		7		7		318		5		5
Other		20,226		20,226		4,419		15,576		576		576		16,101		610		610
Real Estate Construction		-		-		-		-		-		-		-		-		-
Residential Mortgage		1,219		1,098		383		1,485		50		50		1,550		47		47
Consumer and Home Equity		324		302		126		332		10		10		285		6		6
Indirect Consumer		38		38		6		46		-		-		71		1		1
Total	$	68,887	$	59,327	$	5,456	$	57,755	$	2,103	$	2,103	$	60,691	$	2,246	$	2,246

18

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

December 31, 2011	Unpaid				Allowance for
	Principal		Recorded		Loan Losses
(Dollars in thousands)	Balance		Investment		Allocated
With no related allowance recorded:
Commercial	$	2,154	$	2,154	$	-
Commercial Real Estate:
Land Development		12,719		7,124		-
Building Lots		3,662		1,305		-
Other		36,475		32,337		-
Real Estate Construction		-		-		-
Residential Mortgage		-		-		-
Consumer and Home Equity		-		-		-
Indirect Consumer		-		-		-
With an allowance recorded:
Commercial		1,076		1,076		410
Commercial Real Estate:
Land Development		2,952		2,952		442
Building Lots		477		477		265
Other		17,518		17,150		2,696
Real Estate Construction		-		-		-
Residential Mortgage		1,802		1,681		481
Consumer and Home Equity		193		193		109
Indirect Consumer		123		123		39
Total	$	79,151	$	66,572	$	4,442

							Three Months Ended						Six Months Ended
							June 30, 2011						June 30, 2011
June 30, 2011	Unpaid				Allowance for		Average		Interest		Cash Basis		Average		Interest		Cash Basis
	Principal		Recorded		Loan Losses		Recorded		Income		Interest		Recorded		Income		Interest
(Dollars in thousands)	Balance		Investment		Allocated		Investment		Recognized		Recognized		Investment		Recognized		Recognized
With no related allowance recorded:
Commercial	$	3,115	$	3,114	$	-	$	1,689	$	80	$	80	$	1,230	$	58	$	58
Commercial Real Estate:
Land Development		22,165		13,012		-		9,019		188		188		7,869		164		164
Building Lots		-		-		-		-		-		-		-		-		-
Other		40,640		38,311		-		41,228		1,680		1,680		38,263		1,593		1,593
Real Estate Construction		1,717		998		-		644		8		8		491		17		17
Residential Mortgage		-		-		-		-		-		-		-		-		-
Consumer and Home Equity		-		-		-		-		-		-		-		-		-
Indirect Consumer		-		-		-		-		-		-		-		-		-
With an allowance recorded:
Commercial		988		988		566		1,326		63		63		1,403		67		67
Commercial Real Estate:
Land Development		817		817		1,042		9,481		198		198		12,096		253		253
Building Lots		3,663		1,654		348		2,542		7		7		2,838		5		5
Other		24,211		24,211		5,406		25,419		1,036		1,036		26,143		1,088		1,088
Real Estate Construction		-		-		-		-		-		-		361		13		13
Residential Mortgage		1,406		1,311		220		1,591		24		24		1,597		3		3
Consumer and Home Equity		247		247		130		273		-		-		294		-		-
Indirect Consumer		176		176		33		157		1		1		135		-		-
Total	$	99,145	$	84,839	$	7,745	$	93,369	$	3,285	$	3,285	$	92,720	$	3,261	$	3,261

19

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

The following table presents the recorded investment in restructured, nonaccrual and loans past due over 90 days still on accrual by class of loans as of June 30, 2012 and December 31, 2011.

					Loans Past Due
June 30, 2012					Over 90 Days		Non-accrual
	Restructured on		Restructured on		Still		excluding
(Dollars in thousands)	Non-Accrual Status		Accrual Status		Accruing		Restructured
Commercial	$	-	$	1,273		-	$	672
Commercial Real Estate:
Land Development		679		3,577		-		1,084
Building Lots		-		613		-		417
Other		21,165		4,326		-		13,138
Real Estate Construction		-		-		-		-
Residential Mortgage		-		303		-		681
Consumer and Home Equity		-		24		-		183
Indirect Consumer		-		-		-		42
Total	$	21,844	$	10,116		-	$	16,217

					Loans Past Due
December 31, 2011					Over 90 Days		Non-accrual
	Restructured on		Restructured on		Still		excluding
(Dollars in thousands)	Non-Accrual Status		Accrual Status		Accruing		Restructured
Commercial	$	31	$	195		-	$	584
Commercial Real Estate:
Land Development		1,705		-		-		3,184
Building Lots		-		-		-		1,782
Other		15,961		15,522		-		14,879
Real Estate Construction		-		-		-		-
Residential Mortgage		335		305		-		969
Consumer and Home Equity		-		25		-		234
Indirect Consumer		-		-		-		86
Total	$	18,032	$	16,047		-	$	21,718

20

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

The following table presents the aging of the unpaid principal in past due loans as of June 30, 2012 and December 31, 2011 by class of loans:

June 30, 2012	30-59		60-89		Greater than
	Days		Days		90 Days		Total		Loans Not
(Dollars in thousands)	Past Due		Past Due		Past Due		Past Due		Past Due		Total
Commercial	$	148	$	-	$	837	$	985	$	23,880	$	24,865
Commercial Real Estate:
Land Development		1,950		352		1,617		3,919		25,853		29,772
Building Lots		-		-		417		417		2,325		2,742
Other		2,837		5,303		26,061		34,201		315,100		349,301
Real Estate Construction		-		-		-		-		3,950		3,950
Residential Mortgage		1,133		736		2,028		3,897		139,376		143,273
Consumer and Home Equity		341		93		322		756		63,441		64,197
Indirect Consumer		221		71		39		331		19,169		19,500
Total (1)	$	6,630	$	6,555	$	31,321	$	44,506	$	593,094	$	637,600

(1) Includes loans held for sale in probable branch divestiture

December 31, 2011	30-59		60-89		Greater than
	Days		Days		90 Days		Total		Loans Not
(Dollars in thousands)	Past Due		Past Due		Past Due		Past Due		Past Due		Total
Commercial	$	424	$	469	$	1,426	$	2,319	$	27,816	$	30,135
Commercial Real Estate:
Land Development		-		-		2,420		2,420		33,504		35,924
Building Lots		-		-		1,782		1,782		2,098		3,880
Other		5,333		6,467		17,815		29,615		389,366		418,981
Real Estate Construction		-		-		-		-		4,925		4,925
Residential Mortgage		331		812		3,677		4,820		147,046		151,866
Consumer and Home Equity		310		261		638		1,209		68,762		69,971
Indirect Consumer		327		95		86		508		21,384		21,892
Total (1)	$	6,725	$	8,104	$	27,844	$	42,673	$	694,901	$	737,574

(1) Includes loans held for sale in probable branch divestiture and probable loan sale

Troubled Debt Restructurings:

We have allocated $859,000 and $937,000 of specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of June 30, 2012 and December 31, 2011. We are not committed to lend additional funds to debtors whose loans have been modified in a troubled debt restructuring. Specific reserves are generally assessed prior to loans being modified as a TDR, as most of these loans migrate from our internal watch list and have been specifically reserved for as part of our normal reserving methodology.

During the quarter and six month periods ending June 30, 2012, the terms of certain loans were modified as troubled debt restructurings. The modification of the terms of such loans included one or a combination of the following: a reduction of the stated interest rate of the loan; an extension of the maturity date at a stated rate of interest lower than the current market rate for new debt with similar risk; or a permanent reduction of the recorded investment in the loan.

Modifications involving a reduction of the stated interest rate of the loan were for periods ranging from six months to one year. Modifications involving an extension of the maturity date were for periods ranging from three to six months.

21

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

The following tables present loans by class modified as troubled debt restructurings that occurred during the periods ending June 30, 2012 and 2011:

	Three Months Ended						Three Months Ended
	June 30, 2012						June 30, 2011
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
			Outstanding		Outstanding				Outstanding		Outstanding
	Number		Recorded		Recorded		Number		Recorded		Recorded
(Dollars in thousands)	of Loans		Investment		Investment		of Loans		Investment		Investment
Troubled Debt Restructurings:
Commercial		-	$	-	$	-		-	$	-	$	-
Commercial Real Estate:
Land Development		1		2,853		2,853		-		-		-
Building Lots		2		613		613		-		-		-
Other		3		1,088		1,088		2		10,133		10,133
Real Estate Construction		-		-		-		-		-		-
Residential Mortgage		-		-		-		1		197		197
Consumer and Home Equity		-		-		-		-		-		-
Indirect Consumer		-		-		-		-		-		-
Total		6	$	4,554	$	4,554		3	$	10,330	$	10,330

	Six Months Ended						Six Months Ended
	June 30, 2012						June 30, 2011
			Pre-Modification		Post-Modification				Pre-Modification		Post-Modification
			Outstanding		Outstanding				Outstanding		Outstanding
	Number		Recorded		Recorded		Number		Recorded		Recorded
(Dollars in thousands)	of Loans		Investment		Investment		of Loans		Investment		Investment
Troubled Debt Restructurings:
Commercial		1	$	1,094	$	1,094		1	$	175	$	175
Commercial Real Estate:
Land Development		3		4,251		4,110		-		-		-
Building Lots		2		613		613		-		-		-
Other		5		1,139		1,139		7		24,349		24,205
Real Estate Construction		-		-		-		-		-		-
Residential Mortgage		-		-		-		2		652		557
Consumer and Home Equity		-		-		-		-		-		-
Indirect Consumer		-		-		-		-		-		-
Total		11	$	7,097	$	6,956		10	$	25,176	$	24,937

The troubled debt restructurings described above increased the allowance for loan losses allocated to troubled debt restructurings by $67,000 and $316,000 for the three months ended June 30, 2012 and 2011, and by $256,000 and $3.9 million for the six months ended June 30, 2012 and 2011. Typically, these loans have been allocated an allowance prior to their formal modification. The troubled debt restructurings described above resulted in charge-offs of $141,000 for the three and six month periods ended June 30, 2012 and $239,000 for the three and six month periods ended June 30, 2011.

22

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

The following tables present loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the periods ending June 30, 2012 and 2011:

	Three Months Ended				Three Months Ended
	June 30, 2012				June 30, 2011
	Number		Recorded		Number		Recorded
(Dollars in thousands)	of Loans		Investment		of Loans		Investment
Troubled Debt Restructurings:
Commercial		-	$	-		-	$	-
Commercial Real Estate:
Land Development		1		533		-		-
Building Lots		-		-		-		-
Other		1		10,068		1		844
Real Estate Construction		-		-		-		-
Residential Mortgage		-		-		1		361
Consumer and Home Equity		-		-		-		-
Indirect Consumer		-		-		-		-
Total		2	$	10,601		2	$	1,205

	Six Months Ended				Six Months Ended
	June 30, 2012				June 30, 2011
	Number		Recorded		Number		Recorded
(Dollars in thousands)	of Loans		Investment		of Loans		Investment
Troubled Debt Restructurings:
Commercial		-	$	-		1	$	8
Commercial Real Estate:
Land Development		2		3,386		-		-
Building Lots		-		-		-		-
Other		1		10,068		1		844
Real Estate Construction		-		-		-		-
Residential Mortgage		-		-		1		361
Consumer and Home Equity		-		-		-		-
Indirect Consumer		-		-		-		-
Total		3	$	13,454		3	$	1,213

For disclosure purposes, a loan is considered to be in payment default once it is 90 days contractually past due under the modified terms. The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses by $309,000 and $9,000 for the three months ended June 30, 2012 and 2011, and by $309,000 and $13,000 for the six months ended June 30, 2012 and 2011. The troubled debt restructurings described above resulted in charge-offs of $141,000 for the three and six months periods ended June 30, 2012 and $220,000 for the three and six month periods ended June 30, 2011.

23

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

Credit Quality Indicators:

We categorize loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information, and current economic trends, among other factors. We analyze loans individually by classifying the loans as to credit risk. This analysis includes commercial and commercial real estate loans. We also evaluate credit quality on residential mortgage, consumer and home equity and indirect consumer loans based on the aging status and payment activity of the loan. This analysis is performed on a monthly basis. We use the following definitions for risk ratings:

Criticized: Loans classified as criticized have a potential weakness that deserves management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the loan or in our credit position at some future date.

Substandard: Loans classified as substandard are inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the institution will sustain some loss if the deficiencies are not corrected.

Doubtful: Loans classified as doubtful have all the weaknesses inherent in those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable.

Loss: Loans classified as loss are considered non-collectible and their continuance as bankable assets is not warranted.

Loans not meeting the criteria above that are analyzed individually as part of the above described process are considered to be pass rated loans. Loans listed as not rated are included in groups of homogeneous loans. For our residential mortgage, consumer and home equity, and indirect consumer homogeneous loans, we also evaluate credit quality based on the aging status of the loan, which was previously presented, and by payment activity.

24

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

4. LOANS – (Continued)

As of June 30, 2012 and December 31, 2011, and based on the most recent analysis performed, the risk category of loans by class of loans is as follows:

June 30, 2012
(Dollars in thousands)	Not Rated		Pass		Criticized		Substandard		Doubtful		Loss		Total
Commercial	$	-	$	19,855	$	3,614	$	1,396	$	-	$	-	$	24,865
Commercial Real Estate:
Land Development		-		18,505		4,756		6,511		-		-		29,772
Building Lots		-		1,190		522		1,030		-		-		2,742
Other		-		278,806		16,658		53,837		-		-		349,301
Real Estate Construction		-		3,950		-		-		-		-		3,950
Residential Mortgage		138,069		-		457		4,747		-		-		143,273
Consumer and Home Equity		62,587		-		696		914		-		-		64,197
Indirect Consumer		19,346		-		20		134		-		-		19,500
Total (1)	$	220,002	$	322,306	$	26,723	$	68,569	$	-	$	-	$	637,600

(1) Includes loans held for sale in probable branch divestiture

December 31, 2011
(Dollars in thousands)	Not Rated		Pass		Criticized		Substandard		Doubtful		Loss		Total
Commercial	$	-	$	24,082	$	1,634	$	4,389	$	30	$	-	$	30,135
Commercial Real Estate:
Land Development		-		20,656		5,192		10,076		-		-		35,924
Building Lots		-		1,549		549		1,782		-		-		3,880
Other		-		338,483		22,746		57,752		-		-		418,981
Real Estate Construction		-		4,925		-		-		-		-		4,925
Residential Mortgage		146,003		-		573		5,290		-		-		151,866
Consumer and Home Equity		68,101		-		729		1,141		-		-		69,971
Indirect Consumer		21,627		-		4		261		-		-		21,892
Total (1)	$	235,731	$	389,695	$	31,427	$	80,691	$	30	$	-	$	737,574

(1) Includes loans held for sale in probable branch divestiture and probable loan sale

The following table presents the unpaid principal balance in residential mortgage, consumer and home equity and indirect consumer loans based on payment activity as of June 30, 2012 and December 31, 2011:

June 30, 2012	Residential		Consumer &		Indirect
(Dollars in thousands)	Mortgage		Home Equity		Consumer
Performing	$	142,592	$	64,014	$	19,458
Restructured on non-accrual		-		-		-
Non-accrual		681		183		42
Total	$	143,273	$	64,197	$	19,500

December 31, 2011	Residential		Consumer &		Indirect
(Dollars in thousands)	Mortgage		Home Equity		Consumer
Performing	$	150,562	$	69,737	$	21,806
Restructured on non-accrual		335		-		-
Non-accrual		969		234		86
Total	$	151,866	$	69,971	$	21,892

25

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

5. REAL ESTATE ACQUIRED THROUGH FORECLOSURE

A summary of the real estate acquired through foreclosure activity is as follows:

	June 30,			December 31,
(Dollars in thousands)	2012			2011
Beginning balance	$	29,083		$	25,807
Additions		15,361			19,416
Sales		(4,372	)		(6,877	)
Writedowns		(3,543	)		(9,263	)
Ending balance	$	36,529		$	29,083

The increase in real estate acquired through foreclosure expense for the three and six month periods ended June 30, 2012 was primarily due to a $1.5 million termination fee paid that was related to the termination of a property investment and management agreement on a residential development held in other real estate owned.

6. INCOME TAXES

The calculation for the income tax provision or benefit generally does not consider the tax effects of changes in other comprehensive income, or OCI, which is a component of shareholders’ equity on the balance sheet.  However, an exception is provided in certain circumstances, such as when there is a full valuation allowance against net deferred tax assets, there is a loss from continuing operations and income in other components of the financial statements.  In such a case, pre-tax income from other categories, such as changes in OCI, must be considered in determining a tax benefit to be allocated to the loss from continuing operations.  For the quarter ended June 30, 2012 and June 30, 2011, this resulted in $0 and $1.3 million of income tax benefit allocated to continuing operations. For the six month period ended June 30, 2012 and 2011, this resulted in $0 and $1.5 million of income tax benefit allocated to continuing operations.

A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010 and 2011. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at June 30, 2012 and December 31, 2011.

7. EARNINGS (LOSS) PER SHARE

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

	Three Months Ended						Six Months Ended
(Amounts in thousands,	June 30,						June 30,
except per share data)	2012			2011			2012			2011
Basic:
Net income/(loss)	$	(4,139	)	$	(11,904	)	$	(4,429	)	$	(13,974	)
Less:
Preferred stock dividends		(250	)		(250	)		(500	)		(500	)
Accretion on preferred stock discount		(13	)		(13	)		(27	)		(27	)
Net income (loss) available to common shareholders	$	(4,402	)	$	(12,167	)	$	(4,956	)	$	(14,501	)
Weighted average common shares		4,767			4,740			4,764			4,738
Diluted:
Weighted average common shares		4,767			4,740			4,764			4,738
Dilutive effect of stock options and warrants		-			-			-			-
Weighted average common and incremental shares		4,767			4,740			4,764			4,738
Earnings (Loss) Per Common Share:
Basic	$	(0.92	)	$	(2.57	)	$	(1.04	)	$	(3.06	)
Diluted	$	(0.92	)	$	(2.57	)	$	(1.04	)	$	(3.06	)

26

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

7. EARNINGS (LOSS) PER SHARE – (Continued)

Stock options for 276,940 and 266,521 shares of common stock were not included in the June 30, 2012 and 2011 computation of diluted earnings per share for the quarter and year to date because their impact was anti-dilutive. Warrants to purchase 215,983 shares at June 30, 2012 and 2011 were not included in the computation because their impact was also anti-dilutive.

8. STOCK BASED COMPENSATION PLAN

Under our 2006 Stock Option and Incentive Compensation Plan, which is shareholder approved, we may grant restricted stock and incentive or non-qualified stock options to key employees and directors for a total of 727,080 shares of our common stock. We believe that the ability to award stock options and other forms of stock-based incentive compensation can assist us in attracting and retaining key employees. Stock-based incentive compensation is also a means to align the interests of key employees with those of our stockholders by providing awards intended to reward recipients for our long-term growth. The option to purchase shares vest over periods of one to five years and expire ten years after the date of grant. We issue new shares of common stock upon the exercise of stock options. If options or awards granted under the 2006 Plan expire or terminate for any reason without having been exercised in full or released from restriction, the corresponding shares shall again be available for option or award for the purposes of the Plan. At June 30, 2012, options and restricted stock available for future grant under the 2006 Plan totaled 334,840.

Compensation cost related to options and restricted stock granted under the 2006 Plan that was charged against earnings for the six month periods ended June 30, 2012 and 2011 was $92,000 and $95,000. As of June 30, 2012 there was $447,000 of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under the 2006 Plan. That cost is expected to be recognized over a weighted-average period of 3.2 years.

Stock Options – The fair value of each option award is estimated on the date of grant using the Black-Scholes option valuation model that uses various weighted-average assumptions. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. The expected volatility is based on the fluctuation in the price of a share of stock over the period for which the option is being valued and the expected life of the options granted represents the period of time the options are expected to be outstanding.

The weighted-average assumptions for options granted during the three month period ended June 30, 2012 and the resulting estimated weighted average fair value per share is presented below. No other options have been granted during 2012.

	June 30,
	2012
Assumptions:
Risk-free interest rate		1.82	%
Expected dividend yield		-	%
Expected life (years)		10
Expected common stock market price volatility		53	%
Estimated fair value per share	$	1.95

27

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

8. STOCK BASED COMPENSATION PLAN – (Continued)

A summary of option activity under the 2006 Plan for the six month period ended June 30, 2012 is presented below:

						Weighted
				Weighted		Average
	Number			Average		Remaining		Aggregate
	of			Exercise		Contractual		Intrinsic
	Options			Price		Term		Value
								(Dollars In Thousands)
Outstanding, beginning of period		363,240		$	9.62
Granted during period		35,000			3.08
Forfeited during period		(6,000	)		1.95
Exercised during period		-			-
Outstanding, end of period		392,240		$	9.15		7.3	$	83
Eligible for exercise at period end		143,416		$	17.81		4.6	$	-

There were no options exercised, modified or settled in cash for the six month periods ended June 30, 2012 and 2011. Management expects all outstanding unvested options will vest.

Restricted Stock – In addition to stock options, on December 31, 2010, we granted 36,855 shares of restricted common stock at the weighted average current market price of $4.07. No restricted stock had been granted prior to December 31, 2010. The restricted stock vests on December 31, 2012, provided that the recipient has continued to perform substantial services for the Bank through that date.  The restricted stock will become 100% vested before the vesting date upon the recipient’s death or disability or a change of control event as defined by federal regulations. Any dividends declared on the restricted stock prior to vesting will be retained and paid only on the date of vesting. The recipient may not transfer, pledge or dispose of the restricted stock before the date of vesting, and thereafter only in proportion to percentage of the preferred shares originally issued to the U.S. Treasury that have been redeemed. As of June 30, 2012 there was $37,000 of total unrecognized compensation cost related to the restricted stock. That cost is expected to be recognized over the remaining vesting period of .50 years.

9. FAIR VALUE

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

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

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

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

28

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

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

Securities: The fair values of most debt securities are determined by a matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities (Level 2 inputs). In certain cases, such as trust preferred securities, where there is limited activity or less transparency around inputs to the valuation, securities are classified within Level 3 of the valuation hierarchy. The fair values of Level 3 trust preferred securities are determined by an independent third party. These valuations are then reviewed by certain accounting associates and the CFO. For trust preferred securities, discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations. At least annually, a third party is engaged to validate the discounted cash flows and resulting fair value.

Impaired Loans: At the time a loan is considered impaired, it is valued at the lower of cost or fair value. Impaired loans carried at fair value generally receive specific allocations of the allowance for loan losses. For collateral dependent loans, fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value. Non-real estate collateral may be valued using an appraisal, net book value per the borrower’s financial statements, or aging reports, adjusted or discounted based on management’s historical knowledge, changes in market conditions from the time of the valuation, and management’s expertise and knowledge of the client and client’s business, resulting in a Level 3 fair value classification. Once a loan is considered impaired, it is evaluated by a member of the Credit Department on a quarterly basis for additional impairment and adjusted accordingly.

Other Real Estate Owned: Assets acquired through or instead of loan foreclosure are initially recorded at fair value less costs to sell when acquired, establishing a new cost basis. These assets are subsequently accounted for at lower of cost or fair value less estimated costs to sell. Fair value is commonly based on recent real estate appraisals. These appraisals may utilize a single valuation approach or a combination of approaches including comparable sales and the income approach. Adjustments are routinely made in the appraisal process by the independent appraisers to adjust for differences between the comparable sales and income data available. Such adjustments are usually significant and typically result in a Level 3 classification of the inputs for determining fair value.

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by us. Once received, a member of the Credit Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with via independent data sources such as recent market data or industry-wide statistics.

Loans Held For Sale: Loans held for sale associated with a probable branch divestiture and probable loan sale are presented less the purchase discount and are classified within Level 2 of the valuation hierarchy. Loans held for sale at June 30, 2012 include $100.4 million of loans that we expect to sell in branch divestiture transactions and $3.2 million to be sold in the secondary market. The fair value of loans to be sold in the secondary market is estimated based upon the binding contracts and quotes from the third party investors.

29

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

Assets and Liabilities Measured at Fair Value on a Recurring Basis

Assets measured at fair value on a recurring basis are summarized below: There were no transfers between Level 1 and Level 2 during the periods presented.

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	June 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2012		(Level 1)		(Level 2)		(Level 3)
Assets:
U.S. Treasury and agencies	$	13,026	$	-	$	13,026	$	-
Government-sponsored mortgage-backed residential		281,848		-		281,848		-
State and municipal		13,966		-		13,966		-
Corporate bonds		8,182		-		8,182		-
Trust preferred securities		266		-		-		266
Total	$	317,288	$	-	$	317,022	$	266

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2011		(Level 1)		(Level 2)		(Level 3)
Assets:
U.S. Treasury and agencies	$	25,028	$	-	$	25,028	$	-
Government-sponsored mortgage-backed residential		264,691		-		264,691		-
State and municipal		23,794		-		23,794		-
Trust preferred securities		264		-		-		264
Total	$	313,777	$	-	$	313,513	$	264

Between June 2002 and July 2006, we invested in four available-for-sale and one held-to-maturity investment grade tranches of trust preferred collateralized debt obligation (“CDO”) securities.  The securities were issued and are referred to as Preferred Term Securities Limited (“PreTSL”).  The underlying collateral for the PreTSL is unguaranteed pooled trust preferred securities issued by banks, insurance companies and REITs geographically dispersed across the United States.  We hold five PreTSL securities, none of which are currently investment grade.

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

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

30

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

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

We received valuation estimates on our trust preferred securities for June 30, 2012.  Those valuation estimates were based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market.  In accordance with current accounting guidance, we determined that a risk-adjusted discount rate appropriately reflects the reporting entity’s estimate of the assumptions that market participants would use in an active market to estimate the selling price of the asset at the measurement date.  

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

The table below presents reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the periods ended June 30, 2012 and 2011:

	Fair Value Measurements						Fair Value Measurements
	Using Significant						Using Significant
	Unobservable Inputs						Unobservable Inputs
	(Level 3)						(Level 3)
	Three Months Ended						Six Months Ended
	June 30,						June 30,
(Dollars in thousands)	2012			2011			2012		2011
Beginning balance	$	268		$	763		$	264	$	346
Total gains or losses:
Impairment charges on securities		-			-			-		(25	)
Included in other comprehensive income		(2	)		(95	)		2		347
Transfers in and/or out of Level 3		-			-			-		-
Ending balance	$	266		$	668		$	266	$	668

The following table presents quantitative information about recurring Level 3 fair value measurements at June 30, 2012.

					Range
	Fair		Valuation	Unobservable	(Weighted
(Dollars in thousands)	Value		Technique	Inputs	Average)
Trust preferred securities	$	266	Discounted cash flow	Discount rate	0.00% - 34.73%
					(21.31%)

The significant unobservable inputs used in the fair value measurement of our trust preferred securities are probabilities of specific-issuer prepayment assumptions, specific-issuer defaults and deferrals and specific-issuer recovery assumptions. Significant increases in specific-issuer prepayment assumptions, specific-issuer defaults and deferrals and specific-issuer recovery assumptions would result in a significantly lower fair value measurement. Conversely, decreases in specific-issuer prepayment assumptions, specific-issuer defaults and deferrals and specific-issuer recovery assumptions would result in a higher fair value measurement.

31

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued

The table below summarizes changes in unrealized gains and losses recorded in earnings for the quarter and six months ended June 30 for Level 3 assets and liabilities that are still held at June 30.

	Changes in Unrealized Gains/Losses				Changes in Unrealized Gains/Losses
	Relating to Assets Still Held at Reporting				Relating to Assets Still Held at Reporting
	Date for the Three Months Ended				Date for the Six Months Ended
	June 30,				June 30,
(Dollars in thousands)	2012		2011		2012		2011
Interest income on securities	$	-	$	-	$	-	$	-
Other changes in fair value		-		-		-		25
Total	$	-	$	-	$	-	$	25

Assets and Liabilities Measured at Fair Value on a Nonrecurring Basis

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

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	June 30,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2012		(Level 1)		(Level 2)		(Level 3)
Assets:
Impaired loans:
Commercial	$	1,037	$	-	$	-	$	1,037
Commercial Real Estate:
Land Development		2,789		-		-		2,789
Building Lots		417		-		-		417
Other		19,314		-		-		19,314
Real Estate Construction		-		-		-		-
Residential Mortgage		4,272		-		-		4,272
Consumer and Home Equity		727		-		-		727
Indirect Consumer		109		-		-		109
Real estate acquired through foreclosure:
Commercial		559		-		-		559
Commercial Real Estate:
Land Development		4,285		-		-		4,285
Building Lots		5,882		-		-		5,882
Other		9,418		-		-		9,418
Residential Mortgage		153		-		-		153
Trust preferred security held-to-maturity		16		-		-		16
Loans held for sale related to probable branch divestiture		100,372		-		100,372		-

32

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

			Quoted Prices in
			Active Markets for		Significant Other		Significant
	December 31,		Identical Assets		Observable Inputs		Unobservable Inputs
(Dollars in thousands)	2011		(Level 1)		(Level 2)		(Level 3)
Assets:
Impaired loans:
Commercial	$	2,643	$	-	$	-	$	2,643
Commercial Real Estate:
Land Development		7,929		-		-		7,929
Building Lots		1,517		-		-		1,517
Other		27,668		-		-		27,668
Real Estate Construction		-		-		-		-
Residential Mortgage		4,384		-		-		4,384
Consumer and Home Equity		937		-		-		937
Indirect Consumer		194		-		-		194
Real estate acquired through foreclosure:
Commercial		728		-		-		728
Commercial Real Estate:
Land Development		4,285		-		-		4,285
Building Lots		5,369		-		-		5,369
Other		6,300		-		-		6,300
Residential Mortgage		172		-		-		172
Trust preferred security held-to-maturity		24		-		-		24
Loans held for sale		45,829		-		45,829		-

Impaired loans, which are measured for impairment using the fair value of the collateral for collateral dependent loans, had a carrying amount of $33.4 million, with a valuation allowance of $4.8 million, resulting in an additional provision for loan losses of $1.4 million and $1.9 million for the three and six month periods ended June 30, 2012. Values for collateral dependent loans are generally based on appraisals obtained from licensed real estate appraisals and in certain circumstances consideration of offers obtained to purchase properties prior to foreclosure. Appraisals for commercial real estate generally use three methods to derive value: cost, sales or market comparison and income approach. The cost method bases value on the estimated cost to replace the current property after considering adjustments for depreciation. Values of the market comparison approach evaluate the sales price of similar properties in the same market area. The income approach considers net operating income generated by the property and an investors required return. The final value is a reconciliation of these three approaches and takes into consideration any other factors management deems relevant to arrive at a representative fair value.

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Fair value adjustments of $1.9 million and $3.5 million were made to real estate owned during the quarter and six months ended June 30, 2012.

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

We received valuation estimates on our trust preferred security for June 30, 2012.  Those valuation estimates were based on proprietary pricing models utilizing significant unobservable inputs in an inactive market with distressed sales, Level 3 inputs, rather than actual transactions in an active market.  In accordance with current accounting guidance, we determined that a risk-adjusted discount rate appropriately reflects the reporting entity’s estimate of the assumptions that market participants would use in an active market to estimate the selling price of the asset at the measurement date. The discount rate is calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality.

33

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

The following table presents quantitative information about level 3 fair value measurements for financial instruments measured at fair value on a non-recurring basis at June 30, 2012.

(Dollars in thousands)	Fair Value		Valuation Technique(s)	Unobservable Input(s)	Range (Weighted Average)(1)
Impaired loans:
Commercial	$	1,037	Sales comparison approach	Adjustment for differences  between comparable sales	6.43%
Commercial Real Estate:
Land Development		2,789	Income approach	Capitalization rate	20.00% – 24.50% (23.03%)
			Sales comparison approach	Adjustment for differences  between comparable sales	0.00%
Building Lots		417	Sales comparison approach	Adjustment for differences between comparable sales	2.49%
Other		19,314	Income approach	Capitalization rate	7.70% – 16.00% (11.30%)
			Sales comparison approach	Adjustment for differences between comparable sales	0.00% – 21.87% (12.25%)
Residential Mortgage		4,272	Sales comparison approach	Adjustment for differences between comparable sales	0.00% – 19.00% (14.90%)
Consumer and Home Equity		727	Sales comparison approach	Adjustment for differences between comparable sales	0.00% – 8.29% (2.10%)
Indirect Consumer		109	NADA value
Real estate acquired through foreclosure:
Commercial		559	Sales comparison approach	Adjustment for differences between comparable sales	9.62% – 9.67% (9.62%)
Commercial Real Estate:
Land Development		4,285	Income approach	Capitalization rate	8.50%
			Sales comparison approach	Adjustment for differences  between comparable sales	3.44% – 25.00% (11.78%)
Building Lots		5,882	Income approach	Capitalization rate	24.00% – 28.00% (26.23%)
Other		9,418	Income approach	Capitalization rate	8.50% – 10.50% (9.75%)
			Sales comparison approach	Adjustment for differences between comparable sales	2.75% – 5.19% (3.20%)
Residential Mortgage		153	Sales comparison approach	Adjustment for differences  between comparable sales	1.11% – 3.00% (2.63%)
Trust preferred security held-to-maturity		16	Discounted cash flow	Discount rate	15.47%

(1) Unobservable inputs with a single discount listed include only one property.

34

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

Fair Value of Financial Instruments

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

			June 30, 2012
(Dollars in thousands)	Carrying		Fair Value Measurements
	Value		Total		Level 1		Level 2		Level 3
Financial assets:
Cash and due from banks	$	154,114		154,114		7,116		146,998		-
Mortgage loans held for sale		3,220		3,282		-		3,282		-
Loans, net		492,201		532,823		-		-		532,823
FHLB stock		4,805		N/A		N/A		N/A		N/A
Financial liabilities:
Deposits		1,089,302		1,107,732		-		1,107,732		-
Advances from Federal Home Loan Bank		27,666		30,601		-		30,601		-
Subordinated debentures		18,000		12,719		-		-		12,719

(Dollars in thousands)	December 31, 2011
	Carrying		Fair
	Value		Value
Financial assets:
Cash and due from banks	$	92,236	$	92,236
Mortgage loans held for sale		10,187		10,326
Loans, net		628,800		643,797
FHLB stock		4,805		N/A
Financial liabilities:
Deposits		1,122,794		1,134,843
Advances from Federal Home Loan Bank		27,736		30,888
Subordinated debentures		18,000		12,448

The methods and assumptions, not previously presented, used to estimate fair values are described below:

(a) Cash and due from banks

The carrying amount of cash on hand approximates fair value and is classified as a Level 1. The carrying amount of cash due from bank accounts is classified as a Level 2.

(b) Mortgage loans held for sale

The fair value of mortgage loans held for sale is estimated based upon the binding contracts and quotes from third party investors resulting in a Level 2 classification.

(c) Loans, net

Fair values of loans are estimated as follows: For variable rate loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values resulting in a Level 3 classification. Fair values for other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality resulting in a Level 3 classification. Impaired loans are valued at the lower of cost or fair value as described previously. The methods utilized to estimate the fair value of loans do not necessarily represent an exit price. The carrying amount of related accrued interest receivable, due to its short-term nature, approximates its fair value, is not significant and is not disclosed.

35

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

9. FAIR VALUE - (Continued)

(d) FHLB Stock

It is not practical to determine the fair value of FHLB stock due to restrictions placed on its transferability.

(e) Deposits

The fair value disclosed for fixed rate deposits and variable rate deposits with infrequent re-pricing or re-pricing limits, is calculated using the FHLB advance curve to discount cash flows using current market rates applied to the estimated life resulting in a Level 2 classification. The carrying amount of related accrued interest payable, due to its short-term nature, approximates its fair value, is not significant and is not disclosed.

(f) Advances from Federal Home Loan Bank

The fair value of the FHLB advances is obtained from the FHLB and is calculated by discounting contractual cash flow using an estimated interest rate based on the current rates available to us for debt of similar remaining maturities and collateral terms resulting in a Level 2 classification.

(g) Subordinated debentures

The fair value for subordinated debentures is calculated using discounted cash flow analyses based on the current borrowing rates for similar types of borrowing arrangements resulting in a Level 3 classification.

(h) Off-balance Sheet Instruments

Fair values for off-balance sheet, credit-related financial instruments are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the counterparties’ credit standing. The fair value of commitments is not material.

36

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

10. PREFERRED STOCK

On January 9, 2009, we issued $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the United States Treasury under its Capital Purchase Program (“CPP”). The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares pay cumulative dividends quarterly at a rate of 5% per year for the first five years and will reset to a rate of 9% per year on January 9, 2014. The Senior Preferred Shares may be redeemed at any time, subject to prior regulatory approval. We also have the ability to defer dividend payments at any time, at our option.

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

On October 29, 2010, we gave written notice to the U.S. Treasury that effective with the fourth quarter of 2010, we were suspending the payment of regular quarterly cash dividends on our Senior Preferred Shares. Under the CPP provisions, failure to pay dividends for six quarters would trigger the right of the holder of our Senior Preferred Shares to appoint representatives to our Board of Directors. A representative from the U.S. Treasury attended Board meetings during the first half of 2012. The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes. As of June 30, 2012, these accrued but unpaid dividends totaled $1.9 million.

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

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

On June 19, 2012, the U.S. Treasury (“Treasury”) notified us that the Company’s Series A Preferred Stock would be included in one of a series of pooled auctions of the securities of financial institutions purchased by Treasury under its Capital Purchase Program, which were scheduled to be conducted in the fall of 2012. Treasury also informed us that we could submit a bid to purchase all of our Series A Preferred Stock in advance of the pooled auction, either by us directly or by one or more qualified investors designated by us. Acceptance of any bid is at the discretion of the Treasury, assuming the bid meets a minimum price established internally by Treasury. Our Board of Directors engaged a financial advisor to assist it in identifying, selecting and negotiating with qualified accredited investors regarding the terms of a possible bid. On August 6, 2012, we submitted to Treasury a bid by a group of investors designated by us. Treasury has acknowledged receipt of the bid, which is currently under review. If Treasury accepts the bid and completes a sale to the bidders, the full $20 million stated value of our Series A Preferred Stock would remain outstanding and our obligation to pay dividends, currently at an annual rate of 5% and increasing to 9% in January 2014, would continue until the securities are retired. If the bid is not accepted, Treasury has the option to give us and our designated bidders an opportunity to negotiate a higher purchase price or to include our Series A Preferred Stock in a future pooled or individual auction.

11. STOCKHOLDERS’ EQUITY

Regulatory Capital Requirements – The Corporation and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action.

Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required.

37

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

11. STOCKHOLDERS’ EQUITY - (Continued)

Quantitative measures established by regulation to ensure capital adequacy require the Corporation and the Bank to maintain minimum amounts and ratios (set forth in the following table) of Total and Tier I capital (as defined in the regulations) to risk weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined).

As a result of the Consent Order the Bank entered into with the FDIC and KDFI described in greater detail in Note 2, the Bank is categorized as a “troubled institution” by bank regulators, which by definition does not permit the Bank to be considered “well-capitalized”.

On March 9, 2012, the Bank entered into a new Consent Order with the FDIC and KDFI. The 2012 Consent Order requires the Bank to achieve the same minimum capital ratios set forth in the January 2011 Consent Order by June 30, 2012. See Note 2 for additional information.

Our actual and required capital amounts and ratios to be considered adequately capitalized are presented below.

(Dollars in thousands)						For Capital
	Actual					Adequacy Purposes
As of June 30, 2012:	Amount		Ratio			Amount		Ratio
Total risk-based capital (to risk-weighted assets)
Consolidated	$	73,946		10.16	%	$	58,241		8.00	%
Bank		77,742		10.68			58,237		8.00
Tier I capital (to risk-weighted assets)
Consolidated		64,757		8.89			29,121		4.00
Bank		68,545		9.42			29,119		4.00
Tier I capital (to average assets)
Consolidated		64,757		5.43			47,698		4.00
Bank		68,545		5.73			47,886		4.00

(Dollars in thousands)						For Capital
	Actual					Adequacy Purposes
As of December 31, 2011:	Amount		Ratio			Amount		Ratio
Total risk-based capital (to risk-weighted assets)
Consolidated	$	79,593		9.87	%	$	64,493		8.00	%
Bank		82,081		10.18			64,486		8.00
Tier I capital (to risk-weighted assets)
Consolidated		69,425		8.61			32,246		4.00
Bank		71,914		8.92			32,243		4.00
Tier I capital (to average assets)
Consolidated		69,425		5.71			48,666		4.00
Bank		71,914		5.86			49,111		4.00

The 2012 Consent Order requires the Bank to achieve the minimum capital ratios presented below by June 30, 2012:

	Actual as of			Ratio Required
	6/30/2012			by Consent Order
Total capital to risk-weighted assets		10.68	%		12.00	%
Tier 1 capital to average total assets		5.73	%		9.00	%

The divestiture of our Indiana franchise, combined with the impending sale of our four Louisville banking centers, is projected to increase our Tier I capital ratio from 5.73% to over 8.50% and increase our total risk-based capital ratio from 10.68% to over 12.00% based on June 30, 2012 financial information. See Note 2 for additional information.

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Item 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION

AND RESULTS OF OPERATIONS

GENERAL

We operate 17 full-service banking centers and a commercial private banking center in six contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area. Our markets range from Louisville in Jefferson County, Kentucky approximately 40 miles north of our headquarters in Elizabethtown, Kentucky to Hart County, Kentucky, approximately 30 miles south of Elizabethtown. Our markets are supported by a diversified industry base and have a regional population of over 1 million. We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky. In aggregate, 23% of our deposit market share is in our central Kentucky markets outside of Louisville.

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

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

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

The discussion and analysis section covers material changes in the financial condition since December 31, 2011 and material changes in the results of operations for the three and six month periods ending June 30, 2012 as compared to 2011. It should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the period ended December 31, 2011.

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OVERVIEW

Our performance for the first six months of 2012 continued to be impacted by the unfavorable economic conditions that have persisted since 2007. A new management team is in place with the objective of restoring the institution to soundness and profitability. We have adjusted our policies, procedures and allocated additional resources to address credit quality and facilitate the structure and processes to diversify and strengthen our lending function. We also added personnel to concentrate on working with struggling borrowers, work on more efficient asset resolutions, and strengthen the management of other real estate owned. Credit quality impacted our results during 2012 in the areas of write downs in asset values, resources allocated to the disposition of assets and loan workout activities, lost productivity, net interest income and reversals of tax benefits. We were also carrying substantially more liquid assets as of June 30, 2012 to prepare for the impending branch sales which will settle in cash. We anticipate modest improvement in the net interest margin over the next several quarters once the branch sales are consummated and we continue to restructure the composition of the balance sheet. The increased level of liquidity is anticipated to remain elevated in the near term as loan balances continue to decline.

Our net loss attributable to common shareholders for the quarter ended June 30, 2012 was $4.4 million or $0.92 per diluted common share compared to net loss attributable to common shareholders of $12.2 million or $2.57 per diluted common share for the same period in 2011. Our net loss attributable to common shareholders for the six month period ended June 30, 2012 was $5.0 million or $1.04 per diluted common share compared to a net loss of $14.5 million or $3.06 per diluted common share for the same period a year ago. The six month 2012 results include an $11.1 million decrease in provision for loans losses, write downs and losses on other real estate owned of $3.6 million, a $1.5 million termination fee paid that was related to the termination of a property investment and management agreement on a residential development, a net gain of $1.0 million on the sale of available for sale securities, gains of $613,000 on the sale of real estate acquired through foreclosure, a gain of $175,000 on the sale of a lot held for development and a decrease of $779,000 in FDIC insurance premiums. The sale of securities is mainly a result of a combination of increasing our cash position as we prepare for the sale of the branches as well as our focus to restructure the composition of the balance sheet.

The level of non-performing assets has remained relatively stable over the last six quarters and we continue to see indications that credit quality may be stabilizing. Compared to December 31, 2011, we saw a decline in non-performing loans of 4% and a decline in classified assets of 15%. We sold twenty-three other real estate owned properties totaling $4.4 million during the 2012 period. The net proceeds received from the sale of the majority of these properties exceeded the carrying value we had on the books, indicating an appropriate market value for these other real estate owned properties.

Subsequent to the quarter ending June 30, 2012, we entered into sales contracts on nine other real estate owned properties totaling $20.5 million set to close during the third quarter of 2012, indicating a continued interest in our other real estate owned properties.  One of these sales consists of a bulk sale of fourteen properties which we are carrying at a value of $16.2 million.  The net proceeds after sales expenses will be $15.1 million, resulting  in a $1.1 million charge against these properties for the quarter ending June 30, 2012.  We incurred higher than usual commission and closing costs due to the size of the transaction.  If sold on an individual basis, it is unlikely that we would have taken this type of charge against these properties.  However, if this transaction goes through under these terms, it would represent a 56% decrease to our other real estate owned properties balance of $36.5 million as of June 30, 2012. As with all sales contracts, the final sale is subject to both parties meeting all of the terms and conditions of the contracts. In the event that the terms and conditions are not met, by either of the parties, it is possible that the contracts on these sales will be terminated.

Our non-performing assets are largely comprised of residential housing development assets, building lots, an office building and strip centers most of which are located in Jefferson and Oldham Counties. Non-performing assets were $74.6 million or 6.26% of total assets at June 30, 2012 compared to $68.9 million or 5.61% of total assets at December 31, 2011. The increase in non-performing assets is mainly attributable to an increase of $7.4 million in real estate acquired through foreclosure. We anticipate that our level of real estate acquired through foreclosure will remain at elevated levels for some period of time as foreclosures reflecting both weak economic conditions and soft commercial real estate values continue. During 2011, we had substantially all of our non-performing assets appraised or reappraised, including our high end residential development loans and related other real estate owned and recorded substantial valuation adjustment and charge offs based on those appraisals. The lower values on the appraisals and reviews of properties appraised within the first half of 2012 resulted in $3.6 million in write downs on other real estate owned compared to $9.3 million in total write downs recorded during the first six months of 2011. We believe that we have written down other real estate values to levels that will facilitate their liquidation as indicated by recent sales. We also believe we have appropriately addressed and risk-weighted real estate loans in our portfolio. While deterioration in the portfolio is expected to continue, we believe it will continue to be at a slower pace than the accelerated pace experienced in 2010 and 2011.

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The allowance to total loans (including loans held for sale and the related discounts allocated to those loans in probable branch divestitures) was 2.50% at June 30, 2012 while net charge-offs totaled 91 basis points annualized for 2012, compared to 421 basis points for 2011. Excluding loans held for sale and related discounts, the allowance to total loans is approximately 2.85% at June 30, 2012. We attribute the decrease in net charge-offs for 2012 to our aggressive approach of charging off loans to their liquidation value in 2011 and the relative stabilization of collateral values in 2012 compared to 2011. Non-performing loans were $38.1 million or 5.97% of total loans (including loans held for sale in probable branch divestitures) at June 30, 2012 compared to $39.8 million, or 5.39% of total loans for December 31, 2011. The allowance for loan losses to non-performing loans was 42% at June 30, 2012 compared to 32% at June 30, 2011. The increase in the coverage ratio for 2012 was due to the decrease in non-accrual loans.

Net interest income was $14.0 million for the six month 2012 period compared to $17.0 million for the same 2011 period, while the net interest margin was 2.53% for 2012 compared to 2.88% in 2011. The net interest margin continues to be compressed due to the level of non-performing assets, a decline in average loan balances outstanding, increased liquidity levels and assets being placed into lower yielding investments other than loans. We were carrying substantially more liquid assets as of June 30, 2012 to prepare for the impending branch sales which will settle in cash. We anticipate modest improvement to the net interest margin over the next several quarters as we will not need to carry high levels of liquidity after the branch sales and our focus on restructuring the balance sheet that should result in a decrease to our cost of funds and an improvement to interest income. However, the levels of liquidity may be impacted by acceleration of loan repayments. As a result, we have hired a full time consultant to assist us in being proactive in our efforts to restructure the balance sheet.

Non-interest income increased $3.4 million for the six months ended June 30, 2012, primarily driven by net gains on the sale of investments, gains on the sale of premises and equipment and income earned on other real estate owned properties. Non-interest expense increased $383,000 for the 2012 six month period compared to the 2011 six month period. FDIC insurance premiums decreased $779,000 mainly due to the change in the FDIC’s assessment base and rate structure that went into effect during the second quarter of 2011. The increase in real estate acquired through foreclosure expense was primarily due to a $1.5 million termination fee paid that was related to the termination of a property investment and management agreement on a residential development held in other real estate owned. Loan expense increased due to increases in loan portfolio management expenses and expenses incurred in connection with loan workout activities. The increase in loan expense reflects our elevated level of non-performing assets for 2012.

In its 2012 Consent Order with the FDIC and KDFI, the Bank agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. At June 30, 2012, we were not in compliance with the Tier 1 and total risk-based capital requirements. We notified the bank regulatory agencies that the increased capital levels would not be achieved and anticipate that the FDIC and KDFI will reevaluate our progress toward achieving the higher capital ratios at September 30, 2012. We have also provided them with the pro forma information regarding the Tier 1 and total risk based capital which we are projecting to be over 8.50% and 12.00%, respectively based on June 30, 2012 information and on the consummation of the branch sales.

The 2012 Consent Order requires that if the Bank should be unable to reach the required capital levels by June 30, 2012, and the Bank receives written directions from the FDIC and KDFI to do so, then the Bank would develop, adopt and implement within 30 days a written plan to sell or merge itself into another federally insured financial institution. The 2012 Consent Order requires the Bank to continue to adhere to the plans implemented in response to the 2011 Consent Order, and includes the substantive provisions of the 2011 Consent Order. A copy of the March 9, 2012 Consent Order is included as Exhibit 10.8 to our 2011 Annual Report on Form 10-K filed March 30, 2012.

While the Bank did not meet the mandated capital ratios by June 30, 2012, we have not received any written communications from the FDIC or KDFI directing the Bank to develop, adopt and implement within 30 days a written plan to sell or merge itself into another federally insured financial institution. 

The Bank’s Consent Orders with the FDIC and KDFI require us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends to the Corporation. The Bank is also no longer allowed to accept, renew or rollover brokered deposits, including deposits through the Certificate of Deposit Account Registry Service (CDARs) without first obtaining a written waiver from our regulators.

On April 20, 2011, the Corporation entered into a formal agreement with the Federal Reserve Bank of St. Louis, which requires the Corporation to obtain regulatory approval before declaring any dividends. We also may not redeem shares or obtain additional borrowings without prior approval.

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Bank regulatory agencies can exercise discretion when an institution does not meet the terms of a consent order. The agencies may initiate changes in management, issue mandatory directives, impose monetary penalties or refrain from formal sanctions, depending on individual circumstances. Any action taken by bank regulatory agencies could damage our reputation and have a material adverse effect on our business.

In response to the 2011 Consent Order, we engaged an investment banking firm with expertise in the financial services sector to assist with a review of all of our strategic alternatives as we work to achieve the higher regulatory capital ratios.

One of these strategic alternatives involved the sale of eight branches located outside of our core market. Effective after the close of business on July 6, 2012, we have successfully executed the sale of four banking centers located in Corydon, Elizabeth, Lanesville and Georgetown, Indiana to First Savings Bank, F.S.B. We received a 3.65% percent premium on the $102.3 million of consumer and commercial deposits at closing. They assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received zero premium or discount. We also sold approximately $30.4 million in performing loans at a discount of 0.80%. The consummated transaction resulted in a one-time gain of approximately $2.9 million.

We entered into a Branch Purchase Agreement with First Security Bank of Owensboro, Inc., the banking subsidiary of First Security, Inc., headquartered in Owensboro, Kentucky on May 15, 2012. The agreement provides for the sale of our four banking centers in Louisville, Kentucky to First Security. Under the terms of the Agreement, First Security will assume approximately $210.2 million of deposit liabilities. First Security will pay a deposit premium of approximately $2.9 million comprised of a premium of 2.00% on approximately $153.2 million of deposits and a premium ranging from 0% to 1.00% on approximately $57.0 million of other deposits. First Security will also assume performing loans related to the four branches at a 1.00% discount. The loans being assumed totaled approximately $70.9 million at June 30, 2012. The sale is expected to be completed in the third quarter of 2012 subject to First Security raising additional capital, regulatory approval and other customary closing conditions.

The divestiture of our Indiana franchise, combined with the impending sale of our four Louisville banking centers, is projected to increase our Tier I capital ratio from 5.73% to over 8.50% and increase our total risk-based capital ratio from 10.68% to over 12.00% based on June 30, 2012 financial information. The sale of our four Louisville banking centers is expected to close late in the third quarter of 2012.

Additionally, we continue reducing our non-interest costs where possible to offset the increased credit costs associated with other real estate and non-performing loans while taking into consideration the resources necessary to execute our strategies. We have suspended the annual employee stock ownership contribution, frozen most executive management compensation the past three years and into 2012, frozen most officer compensation for the past year and into 2012, eliminated board of director fees, reduced marketing expenses, community donation expenses, compensation expense through reductions in associates, and implemented various other cost savings initiatives. Expense reductions for 2011 were $1.1 million. We are also in the process of evaluating the remaining terms on existing contracts in an effort to identify expenses that can be eliminated in the near future. These efforts will remain ongoing.

On February 10, 2012, we announced several changes to our management and the board of directors. In addition, on May 15, 2012 we announced the appointment of Frank Perez as Chief Financial Officer of the Corporation and the Bank with responsibility for the overall financial functions. Mr. Perez has over fifteen years of experience in the banking industry as well as experience with publicly traded institutions, capital markets, and working with a troubled institution.

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Our plans for 2012 include the following:

· Continuing to research and evaluate all available strategic options to meet and maintain the required regulatory capital levels and all of the other consent order issues for the Bank. Strategic alternatives include divesting of branch offices, as noted earlier we have already sold four banking centers in the Indiana market and have a Branch Purchase Agreement to sell our four banking centers in the Louisville market. Selling loans as an additional measure to reduce our asset size and as a result improving our regulatory capital ratios. We have sold commercial real estate loans totaling $10.7 million, at par, to First Capital Bank of Kentucky during the first half of 2012.

· Continuing to serve our community banking customers and operate the Corporation and the Bank in a safe and sound manner. We have worked diligently to maintain the strength of our retail and deposit franchise. The strength of this franchise contributes to earnings to help withstand our credit quality issues. In addition, the inherent value of the retail franchise will provide value to the Bank to accomplish the various capital initiatives. As of June 30, 2011 data, we rank in the top three in four of the five counties that we serve. This excludes the Indiana market where we no longer have a presence and the Louisville market in anticipation of the pending sale of those branch centers in September. We rank first in Hardin County and Meade County with market share of approximately 26% and 51%, respectively.

· Continuing to reduce our lending concentration in commercial real estate through natural roll off and we have loan diversification initiatives in place that should improve the Bank’s loan portfolio. The mortgage and consumer lending operations continue to maintain strong credit quality metrics throughout the economic downturn. The diversification of the loan portfolio includes an increased emphasis on retail lending, small business lending, and Small Business Administration (“SBA”) lending which should provide a boost to non-interest fee income. We have already allocated and reallocated resources that should contribute to the successful execution of all of these efforts.

· We have enhanced the resources dedicated to special asset dispositions both on a permanent and temporary basis. This is a necessary step as we increase our ongoing efforts to speed up the disposal of our problem assets. This will significantly reduce the involvement of our commercial lenders in the special asset area allowing them to shift their focus to their existing loan customer base and to generate new business that will support our diversification efforts while stemming off some of the loan roll off. The new lenders that have been hired this year bring a significant amount of experience in real estate and commercial and industrial lending.

· We have added an experienced asset liability management consultant as an additional resource to support our efforts as we restructure the balance sheet, minimize our interest rate risk, and improve the net interest margin.

CRITICAL ACCOUNTING POLICIES

Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry. The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements. Accordingly, as this information changes, the financial statements could change as our estimates, assumptions, and judgments change. Certain policies inherently rely more heavily on the use of estimates, assumptions, and judgments and as such have a greater possibility of producing results that could be materially different than originally reported. We consider our critical accounting policies to include the following:

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

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

Based on our calculation, an allowance of $16.0 million or 2.50% of total loans was our estimate of probable incurred losses within the loan portfolio as of June 30, 2012. Approximately $669,000 of this allowance is allocated to the loans held for sale in our branch divestiture transactions and is based upon the discounts agreed to in those transactions. This estimate required us to record a provision for loan losses on the income statement of $1.9 million for the 2012 period.  If the mix and amount of future charge off percentages differ significantly from those assumptions used by management in making its determination, the allowance for loan losses and provision for loan losses on the income statement could materially increase.

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

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

Real Estate Owned – The estimation of fair value is significant to real estate owned-acquired through foreclosure. These assets are recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets when available. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. Appraisals are performed at least annually, if not more frequently. Typically, appraised values are discounted for the projected sale below appraised value in addition to the selling cost. With certain appraised values where management believes a solid liquidation value has been established, the appraisal has been discounted by the selling cost. We have dedicated a team of associates and management to the resolution and work out of other real estate owned as it has become a larger portion of our assets and a larger area of our risk. Appropriate policies, committees and procedures have been put in place to ensure the proper accounting treatment and risk management of this area.

Income Taxes – The provision for income taxes is based on income or loss as reported in the financial statements. Deferred income tax assets and liabilities are computed for differences between the financial statement and tax basis of assets and liabilities that will result in taxable or deductible amounts in the future. The deferred tax assets and liabilities are computed based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income. An assessment is made as to whether it is more likely than not that deferred tax assets will be realized. Valuation allowances are established when necessary to reduce deferred tax assets to an amount expected to be realized. Income tax expense is the tax payable or refundable for the period plus or minus the change during the period in deferred tax assets and liabilities. Tax credits are recorded as a reduction to tax provision in the period for which the credits may be utilized.

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In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2011 and 2010. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at June 30, 2012 and December 31, 2011.

RESULTS OF OPERATIONS

Net loss attributable to common shareholders for the quarter ended June 30, 2012 was $4.4 million or $0.92 per diluted common share compared to $12.2 million or $2.57 per diluted common share for the same period in 2011. Net loss attributable to common shareholders for the six month period ended June 30, 2012 was $5.0 million or $1.04 per diluted common share compared to $14.5 million or $3.06 per diluted common share for the same period a year ago. The six month 2012 results include a $11.1 million decrease in provision for loans losses, write downs and losses on other real estate owned of $3.6 million, a $1.5 million termination fee paid that was related to the termination of a property investment and management agreement on a residential development, a net gain of $1.0 million on the sale of available for sale securities, gains of $613,000 on the sale of real estate acquired through foreclosure, a gain of $175,000 on the sale of a lot held for development and a decrease of $779,000 in FDIC insurance premiums. The sale of securities is mainly a result of a combination of increasing our cash position as we prepare for the sale of the branches as well as our focus to restructure the composition of the balance sheet. Net loss attributable to common shareholders was also impacted by dividends accrued on preferred shares.

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

The large decline in the volume of interest earning assets and the change in the mix of interest earning assets caused a negative impact on net interest income, which decreased $1.7 million and $3.0 million for the three and six month 2012 periods compared to the prior year periods. Average interest earning assets decreased $81.2 million and $79.1 million for the quarter and six month 2012 periods compared to 2011 due to a decrease in average loans and our efforts to increase liquidity by increasing lower yielding investments. The decrease in average loans was due to loan principal payments, payoffs, charge-offs and the conversion of nonperforming loans to other real estate owned properties. Average loan yields were 5.37% and 5.47% for the three and six month 2012 periods compared to average loan yields of 5.57% and 5.64% for the 2011 periods. Additionally, due to the increased regulatory capital ratios requirement as a result of our written agreement with the FDIC and KDFI, we have intentionally not replaced much of this loan run-off as we continue our efforts to reduce our asset size.

The yield on earning assets averaged 3.88% and 4.07% for the three and six month 2012 periods compared to an average yield on earning assets of 4.61% and 4.69% for 2011. This decrease partially was offset by a decrease in our cost of funds which averaged 1.55% and 1.63% for the quarter and six month 2012 periods compared to an average cost of funds of 1.89% and 1.93% for the same periods in 2011. Net interest margin as a percent of average earning assets decreased 42 basis points to 2.42% for the quarter ended June 30, 2012 and 35 basis points to 2.53% for the six months ended June 30, 2012 compared to 2.84% and 2.88% for the 2011 periods.

We anticipate that we will be able to take advantage of the continued low interest rate environment to reduce our cost of funds as term deposits will be re-priced at more favorable terms.

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AVERAGE BALANCE SHEET

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

	Quarter Ended June 30,
	2012								2011
	Average					Average			Average					Average
(Dollars in thousands)	Balance			Interest		Yield/Cost(5)			Balance			Interest		Yield/Cost(5)
ASSETS
Interest earning assets:
U.S. Treasury and agencies	$	19,399		$	98		2.03	%	$	114,807		$	683		2.39	%
Mortgage-backed securities		309,475			1,498		1.94			113,726			880		3.10
Equity securities		-			-		-			294			11		15.01
State and political subdivision securities (1)		13,755			218		6.36			22,987			402		7.01
Trust preferred securities		1,032			16		6.22			1,100			11		4.01
Corporate bonds		412			1		0.97			-			-		-
Loans (2) (3) (4)		662,340			8,868		5.37			842,611			11,692		5.57
FHLB stock		4,805			56		4.67			4,884			52		4.27
Interest bearing deposits		107,296			57		0.21			99,341			66		0.27
Total interest earning assets		1,118,514			10,812		3.88			1,199,750			13,797		4.61
Less:  Allowance for loan losses		(17,759	)							(24,762	)
Non-interest earning assets		92,289								97,298
Total assets	$	1,193,044							$	1,272,286
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest bearing liabilities:
Savings accounts	$	98,445		$	72		0.29	%	$	118,243		$	165		0.56	%
NOW and money market
accounts		305,064			390		0.51			281,395			582		0.83
Certificates of deposit and other time deposits		605,531			2,983		1.98			681,842			3,927		2.31
FHLB advances		27,678			282		4.09			27,645			280		4.06
Subordinated debentures		18,000			341		7.60			18,000			350		7.80
Total interest bearing liabilities		1,054,718			4,068		1.55			1,127,125			5,304		1.89
Non-interest bearing liabilities:
Non-interest bearing deposits		82,698								75,518
Other liabilities		5,069								1,729
Total liabilities		1,142,485								1,204,372
Stockholders’ equity		50,559								67,914
Total liabilities and stockholders’ equity	$	1,193,044							$	1,272,286
Net interest income				$	6,744							$	8,493
Net interest spread							2.33	%							2.72	%
Net interest margin							2.42	%							2.84	%

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

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

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

(4) Includes loans held for sale.

(5) Annualized

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	Six Months Ended June 30,
	2012								2011
	Average					Average			Average					Average
(Dollars in thousands)	Balance			Interest		Yield/Cost (5)			Balance			Interest		Yield/Cost (5)
ASSETS
Interest earning assets:
U.S. Treasury and agencies	$	21,537		$	230		2.15	%	$	126,081		$	1,580		2.53	%
Mortgage-backed securities		294,883			2,969		2.03			83,846			1,387		3.34
Equity securities		-			-		-			294			21		14.40
State and political subdivision securities (1)		16,636			541		6.56			22,802			791		7.00
Trust preferred securities		1,055			29		5.54			1,103			35		6.40
Corporate bonds		206			1		0.98			-			-		-
Loans (2) (3) (4)		694,733			18,829		5.47			859,876			24,035		5.64
FHLB stock		4,805			103		4.32			4,896			106		4.37
Interest bearing deposits		95,855			104		0.22			109,900			140		0.26
Total interest earning assets		1,129,710			22,806		4.07			1,208,798			28,095		4.69
Less:  Allowance for loan losses		(17,868	)							(23,320	)
Non-interest earning assets		92,995								99,766
Total assets	$	1,204,837							$	1,285,244
LIABILITIES AND STOCKHOLDERS’ EQUITY
Interest bearing liabilities:
Savings accounts	$	96,491		$	143		0.30	%	$	117,097		$	343		0.59	%
NOW and money market accounts		304,972			838		0.55			281,534			1,276		0.91
Certificates of deposit and other time deposits		621,632			6,408		2.08			688,543			7,969		2.33
FHLB advances		27,761			567		4.12			28,116			575		4.12
Subordinated debentures		18,000			682		7.64			18,000			691		7.74
Total interest bearing liabilities		1,068,856			8,638		1.63			1,133,290			10,854		1.93
Non-interest bearing liabilities:
Non-interest bearing deposits		79,215								76,152
Other liabilities		4,858								3,103
Total liabilities		1,152,929								1,212,545
Stockholders’ equity		51,908								72,699
Total liabilities and stockholders’ equity	$	1,204,837							$	1,285,244
Net interest income				$	14,168							$	17,241
Net interest spread							2.44	%							2.76	%
Net interest margin							2.53	%							2.88	%

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

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

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

(4) Includes loans held for sale.

(5) Annualized

47

RATE/VOLUME ANALYSIS

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

	Three Months Ended									Six Months Ended
	June 30,									June 30,
	2012 vs. 2011									2012 vs. 2011
	Increase (decrease)									Increase (decrease)
	Due to change in									Due to change in
							Net									Net
(Dollars in thousands)	Rate			Volume			Change			Rate			Volume			Change
Interest income:
U.S. Treasury and agencies	$	(90	)	$	(495	)	$	(585	)	$	(204	)	$	(1,146	)	$	(1,350	)
Mortgage-backed securities		(431	)		1,049			618			(727	)		2,309			1,582
Equity securities		(8	)		(3	)		(11	)		(11	)		(10	)		(21	)
State and political subdivision securities		(35	)		(149	)		(184	)		(47	)		(203	)		(250	)
Trust preferred securities		6			(1	)		5			(5	)		(1	)		(6	)
Corporate bonds		1			-			1			1			-			1
Loans		(398	)		(2,426	)		(2,824	)		(711	)		(4,495	)		(5,206	)
FHLB stock		5			(1	)		4			(1	)		(2	)		(3	)
Interest bearing deposits		(14	)		5			(9	)		(19	)		(17	)		(36	)
Total interest earning assets		(964	)		(2,021	)		(2,985	)		(1,724	)		(3,565	)		(5,289	)
Interest expense:
Savings accounts		(69	)		(24	)		(93	)		(147	)		(53	)		(200	)
NOW and money market accounts		(238	)		46			(192	)		(537	)		99			(438	)
Certificates of deposit and other time deposits		(532	)		(412	)		(944	)		(827	)		(734	)		(1,561	)
FHLB advances		2			-			2			(1	)		(7	)		(8	)
Subordinated debentures		(9	)		-			(9	)		(9	)		-			(9	)
Total interest bearing liabilities		(846	)		(390	)		(1,236	)		(1,521	)		(695	)		(2,216	)
Net change in net interest income	$	(118	)	$	(1,631	)	$	(1,749	)	$	(203	)	$	(2,870	)	$	(3,073	)

Non-Interest Income and Non-Interest Expense

The following tables compare the components of non-interest income and expenses for the periods ended June 30, 2012 and 2011. The tables show the dollar and percentage change from 2011 to 2012. Below each table is a discussion of significant changes and trends.

	Three Months Ended
	June 30,
(Dollars in thousands)	2012			2011			Change			%
Non-interest income
Customer service fees on deposit accounts	$	1,399		$	1,554		$	(155	)		-10.0	%
Gain on sale of mortgage loans		384			291			93			32.0	%
Gain on sale of investments		598			162			436			269.1	%
Loss on sale of investments		(303	)		(38	)		(265	)		697.4	%
Net impairment losses recognized in earnings		-			(67	)		67			-100.0	%
Loss on sale and write downs of real estate acquired through foreclosure		(2,016	)		(4,651	)		2,635			-56.7	%
Gain on sale of premises and equipment		322			-			322			100.0	%
Gain on sale on real estate acquired through foreclosure		210			96			114			118.8	%
Brokerage commissions		112			108			4			3.7	%
Other income		617			380			237			62.4	%
	$	1,323		$	(2,165	)	$	3,488			161.1	%

48

	Six Months Ended
	June 30,
(Dollars in thousands)	2012			2011			Change			%
Non-interest income
Customer service fees on deposit accounts	$	2,782		$	2,999		$	(217	)		-7.2	%
Gain on sale of mortgage loans		695			556			139			25.0	%
Gain on sale of investments		1,309			231			1,078			466.7	%
Loss on sale of investments		(303	)		(38	)		(265	)		697.4	%
Net impairment losses recognized in earnings		(26	)		(104	)		78			-75.0	%
Loss on sale and write downs of real estate acquired through foreclosure		(3,582	)		(4,886	)		1,304			-26.7	%
Gain on sale of premises and equipment		322			-			322			100.0	%
Gain on sale on real estate acquired through foreclosure		613			121			492			406.6	%
Gain on sale on real estate held for development		175			-			175			100.0	%
Brokerage commissions		207			215			(8	)		-3.7	%
Other income		1,028			734			294			40.1	%
	$	3,220		$	(172	)	$	3,392			1972.1	%

We originate qualified VA, KHC, RHC and conventional secondary market loans and sell them into the secondary market with servicing rights released. Gain on sale of mortgage loans increased for 2012 due to an increase in the volume of loans refinanced, originated and sold.

We invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, mutual funds, stocks and others. During 2012 we recorded a gain on the sale of debt investment securities of $1.3 million. Offsetting this gain was a loss on the sales of debt investment securities of $303,000. Gains and losses on investment securities are infrequent and are not a consistent recurring core source of income. The sale of debt investment securities during 2012 is mainly related to the branch sales as the sale of the branches will be settled in cash. The first sale closed on July 6, 2012 and the second branch sale is expected to close late in the third quarter of 2012.

We recognized other-than-temporary impairment charges of $26,000 for the expected credit loss during the 2012 period on one of our trust preferred securities, compared to $104,000 of impairment charges for 2011. Management believes this impairment was primarily attributable to the current economic environment in which the financial condition of some of the issuers deteriorated. Preferred Term Security VI was called for early redemption in July 2012. We received principal and interest of $209,000 and recorded a gain on sale of $192,000.

Further reducing non-interest income for 2012 was an increase of $1.3 million in losses on the sale and write down of real estate owned properties due to the decline in market value of properties held in this portfolio. Offsetting the losses and write downs were recorded gains of $613,000 on the sale of real estate owned properties.

Through our subsidiary, First Federal Office Park, we hold commercial lots adjacent to our home office on Ring Road in Elizabethtown that are available for sale. During the June 2012 period we recorded $175,000 in gains from a lot sale. All of the original nine lots held for sale have now been sold. We also recorded a gain of $322,000 on the sale of two properties held by the Bank as possible new banking center locations. One lot was located in Clarksville, Indiana and the other in Elizabethtown.

The increase in other income for the 2012 period was the result of increases in income received on real estate owned properties.

			Three Months Ended
			June 30,
(Dollars in thousands)	2012		2011		Change			%
Non-interest expenses
Employee compensation and benefits	$	3,822	$	3,958	$	(136	)		-3.4	%
Office occupancy expense and equipment		782		832		(50	)		-6.0	%
Marketing and advertising		135		164		(29	)		-17.7	%
Outside services and data processing		893		1,056		(163	)		-15.4	%
Bank franchise tax		402		342		60			17.5	%
FDIC insurance premiums		682		906		(224	)		-24.7	%
Amortization of core deposit intangible		62		76		(14	)		-18.4	%
Real estate acquired through foreclosure expense		2,336		646		1,690			261.6	%
Loan expense		656		557		99			17.8	%
Other expense		1,446		1,379		67			4.9	%
	$	11,216	$	9,916	$	1,300			13.1	%

49

			Six Months Ended
			June 30,
(Dollars in thousands)	2012		2011		Change			%
Non-interest expenses
Employee compensation and benefits	$	7,675	$	8,287	$	(612	)		-7.4	%
Office occupancy expense and equipment		1,550		1,643		(93	)		-5.7	%
Marketing and advertising		168		389		(221	)		-56.8	%
Outside services and data processing		1,704		1,853		(149	)		-8.0	%
Bank franchise tax		744		656		88			13.4	%
FDIC insurance premiums		1,097		1,876		(779	)		-41.5	%
Amortization of core deposit intangible		127		153		(26	)		-17.0	%
Real estate acquired through foreclosure expense		2,676		1,028		1,648			160.3	%
Loan expense		1,164		609		555			91.1	%
Other expense		2,800		2,828		(28	)		-1.0	%
	$	19,705	$	19,322	$	383			2.0	%

Employee compensation and benefits is the largest component of non-interest expense. The decrease for 2012 was due to higher insurance claims recorded in 2011 under our self-funded insurance plan and a decrease in the average number of full time equivalent employees. Full time equivalent employees decreased from 333 at June 30, 2011 to 306 at June 30, 2012.

Office occupancy and equipment expense, marketing and advertising related expenses and outside services and data processing related expenses decreased due to cost cutting initiatives.

FDIC insurance premiums decreased for the period mainly due to the change in the FDIC’s assessment base and rate structure that went into effect during the second quarter of 2011.

The increase in real estate acquired through foreclosure expense was primarily due to a $1.5 million termination fee paid that was related to the termination of a property investment and management agreement on a residential development held in other real estate owned.  

Loan expense increased due to increases in loan portfolio management expenses and expenses incurred in connection with loan workout activities. The increase in loan expense reflects our elevated level of non-performing assets for 2012.

Income Taxes

The provision for income taxes includes federal and state income taxes and in 2012 and 2011 reflects a full valuation allowance against all of our deferred tax assets that are not currently recoverable through carry back. We did not record any income tax expense or benefit for the six month period ended June 30, 2012, as an income tax benefit of $2.1 million was offset by an increase in valuation allowance for deferred taxes. An income tax benefit of $1.5 million was recorded for the six months ended June 30, 2011. Our June 30, 2011 tax benefit is entirely due to gains in other comprehensive income that are presented in current operations in accordance with applicable accounting standards. The effective tax rate for the six month period ended June 30, 2012 was 0.0% as compared to 10.0% for 2011. Our future effective income tax rate will fluctuate based on the mix of taxable and tax free investments we make and, to a greater extent, the impact of changes in the required amount of valuation allowance recorded against our net deferred tax assets and our overall level of taxable income.

A valuation allowance related to deferred tax assets is required when it is considered more likely than not that all or part of the benefit related to such assets will not be realized. In assessing the need for a valuation allowance, we considered various factors including our three year cumulative loss position and the fact that we did not meet our forecast levels in 2010, and 2011, primarily due to higher levels of provision for loan loss expense. These factors represent the most significant negative evidence that we considered in concluding that a valuation allowance was necessary at June 30, 2012 and December 31, 2011.

Recording a valuation allowance does not have any impact on our liquidity, nor does it preclude us from using the tax losses, tax credits or other timing differences in the future. To the extent that we generate taxable income in a given quarter, the valuation allowance may be reduced to fully or partially offset the corresponding income tax expense. Any remaining deferred tax asset valuation allowance may be reversed through income tax expense once we can demonstrate a sustainable return to profitability and conclude that it is more likely than not the deferred tax asset will be utilized prior to expiration.

50

ANALYSIS OF FINANCIAL CONDITION

Total assets at June 30, 2012 decreased $37.1 million compared to total assets at December 31, 2011. The decrease was primarily due to a decline of $100.0 million in total loans, including loans held for sale in connection with two probable branch divestitures. This decrease was mainly offset by an increase in cash and cash equivalents of $61.9 million. At quarter end we had increased our liquid assets substantially in anticipation of the impending branch sales which will settle in cash.

Loans

Total loans, including loans held for sale in connection with a probable branch divesture and a probable loan sale, decreased $100.0 million to $637.6 million at June 30, 2012 compared to $737.6 million at December 31, 2011. Our commercial real estate and commercial portfolios decreased $82.2 million to $406.7 million at June 30, 2012. Our residential mortgage loan, real estate construction, consumer and home equity and indirect consumer portfolios all decreased for the 2012 period. The decline in our commercial real estate and commercial loan portfolios is a result of pay-offs, charge-offs on large commercial real estate loans, and commercial loans being transferred to real estate acquired through foreclosure. Charge-offs made up $3.3 million or 3.3 % of this decrease. The decline in the loan portfolio was also due, in part, to our ongoing efforts to resolve problem loans. Additionally, due to the increased regulatory capital ratios requirement as a result of our written agreement with the FDIC and KDFI, we have intentionally not replaced much of this loan run-off as we continue our efforts to reduce our asset size.

	June 30,			December 31,
(Dollars in thousands)	2012			2011
Commercial	$	24,865		$	30,135
Commercial Real Estate:
Land Development		29,772			35,924
Building Lots		2,742			3,880
Other		349,301			418,981
Real estate construction		3,950			4,925
Residential mortgage		143,273			151,866
Consumer and home equity		64,197			69,971
Indirect consumer		19,500			21,892
		637,600			737,574
Less:
Loans held for sale in probable branch divestiture		(101,325	)		(46,112	)
Net deferred loan origination fees		(109	)		(209	)
Allowance for loan losses		(15,300	)		(17,181	)
		(116,734	)		(63,502	)
Net Loans	$	520,866		$	674,072

Allowance and Provision for Loan Losses

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

The Allowance for Loan Loss Review Committee evaluates the allowance for loan losses monthly to maintain a level it believes to be sufficient to absorb probable incurred credit losses existing in the loan portfolio. Periodic provisions to the allowance are made as needed. The Committee determines the allowance by applying loss estimates to graded loans by categories, as described below. When appropriate, a specific reserve will be established for individual loans based upon the risk classification and the estimated potential for loss. In accordance with our credit management processes, we obtain new appraisals on properties securing our non-performing commercial real estate loans and use those appraisals to determine specific reserves within the allowance for loan losses. As we receive new appraisals on properties securing non-performing loans, we recognize charge-offs and adjust specific reserves as appropriate. In addition, the Committee analyzes such factors as changes in lending policies and procedures; real estate market conditions; underwriting standards; collection; charge-off and recovery history; changes in national and local economic business conditions and developments; changes in the characteristics of the portfolio; ability and depth of lending management and staff; changes in the trend of the volume and severity of past due, non-accrual and classified loans; troubled debt restructuring and other loan modifications; and results of regulatory examinations.

51

Further declines in collateral values, including commercial real estate, may impact our ability to collect on certain loans when borrowers are dependent on the values of the real estate as a source of cash flow. Beginning the second half of 2008 and continuing into 2011, we substantially increased our provision for loan losses for our general and specific reserves as we identified adverse conditions. While it is anticipated that there will continue to be challenges in the foreseeable future as we manage the overall level of our credit quality, it appears that credit quality may be stabilizing.

As discussed in Note 2 to the consolidated financial statements, we entered into a Consent Order with bank regulatory agencies. In addition to increasing capital ratios, we agreed to maintain adequate reserves for loan losses, develop and implement a plan to reduce the level of non-performing assets through collection, disposition, charge-off or improvement in the credit quality of the loans, develop and implement a plan to reduce concentrations of credit in commercial real estate loans, implement revised credit risk management practices and credit administration policies and procedures and to report our progress to the regulators.

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

	Three Months Ended					Six Months Ended
	June 30,					June 30,
(Dollars in thousands)	2012			2011		2012			2011
Balance at beginning of period	$	17,329		$	24,591	$	17,181		$	22,665
Loans charged-off:
Residential mortgage		31			204		62			223
Consumer & home equity		158			93		276			222
Commercial & commercial real estate		2,190			16,178		2,990			17,890
Total charge-offs		2,379			16,475		3,328			18,335
Recoveries:
Residential mortgage		-			-		1			-
Consumer & home equity		42			48		86			121
Commercial & commercial real estate		75			27		102			275
Total recoveries		117			75		189			396
Net loans charged-off		2,262			16,400		3,139			17,939
Provision for loan losses		915			9,517		1,927			12,982
Balance at end of period		15,982			17,708		15,969			17,708
Less: Allowance allocated to loans held for
sale in probable branch divestiture		(682	)		-		(669	)		-
Balance at end of period, net	$	15,300		$	17,708	$	15,300		$	17,708
Allowance for loan losses to total loans (1) (2)							2.50	%		2.22	%
Annualized net charge-offs to average
loans outstanding							0.91	%		4.21	%
Allowance for loan losses to
total non-performing loans (2)							42	%		32	%

(1) Includes loans held for sale in probable branch divestiture for 2012

(2) Includes allowance allocated to loans held for sale in probable branch divestiture for 2012

52

Provision for loan loss expense decreased $8.6 million to $915,000 for the three months ended June 30, 2012, compared to the same period ended June 30, 2011. Provision for loan loss decreased $11.1 million to $1.9 million for the six months ended June 30, 2012, compared to the same six month period in 2011. We recorded a smaller provision for 2012 due to a lower level of charge-offs and an improvement in our security and position of certain classified loans during the period. Our provision for loan loss was higher in 2011 due to our efforts to ensure the adequacy of the allowance by adding specific reserves to several large commercial real estate relationships based on updated appraisals of the underlying collateral. We require appraisals and perform evaluations on impaired assets upon initial identification.  Thereafter, we obtain appraisals or perform market value evaluations on impaired assets at least annually.  Recognizing the volatility of certain assets, we assess the transaction and market conditions to determine if updated appraisals are needed more frequently than annually. Additionally, we evaluate the collateral condition and value upon foreclosure. The higher provision for 2011 was also due to our increasing the general reserve provisioning levels for commercial real estate loans due to the general credit quality trend and the higher level of charge-offs.

The allowance for loan losses decreased $2.4 million to $15.3 million from June 30, 2011 to June 30, 2012. The decrease was driven by net charge-offs of $11.6 million taken during 2011 and the first half of 2012. These included specific reserves of $3.2 million on our collateral dependent loans of which $1.9 million was previously reserved for at December 31, 2011, in addition to taking other write downs on loans to reflect updated appraisal information obtained as part of our on-going monitoring of the loan portfolio. Appraisal values declined significantly on one to four family residential developments during 2011. We believe these values are at or near liquidation value at June 30, 2012. We also believe this concentration has been fully identified and properly risk rated. The pass loans in this concentration have been separately evaluated for general allowance allocations. The allowance for loan losses as a percent of total loans was 2.50% for June 30, 2012 compared to 2.22% at June 30, 2011. Specific reserves as allocated to impaired loans made up 33% of the total allowance for loan loss at June 30, 2012 compared to 42% at June 30, 2011. Net charge-offs for the 2012 period included $1.4 million in partial charge-offs compared to partial charge-offs of $14.2 million at June 30, 2011. Allowance for loan losses to total non-performing loans increased to 42% at June 30, 2012 from 32% during the same 2011 period. The increase in the coverage ratio for 2012 was primarily due to the decrease in non-accrual loans for the period.

Federal regulations require banks to classify their own assets on a regular basis. The regulations provide for three categories of classified loans — substandard, doubtful and loss. In addition, we also classify loans as criticized. Loans classified as criticized have a potential weakness that deserves management’s close attention.

The following table provides information with respect to criticized and classified loans for the periods indicated:

	June 30,		March 31,		December 31,		September 30,		June 30,
(Dollars in thousands)	2012		2012		2011		2011		2011
Criticized Loans:
Total Criticized	$	26,723	$	36,753	$	31,427	$	17,893	$	26,972
Classified Loans:
Substandard	$	68,569	$	68,910	$	80,691	$	99,018	$	94,688
Doubtful		-		-		30		345		534
Loss		-		-		-		-		-
Total Classified	$	68,569	$	68,910	$	80,721	$	99,363	$	95,222
Total Criticized and Classified	$	95,292	$	105,663	$	112,148	$	117,256	$	122,194

Total criticized and classified loans declined $26.9 million or 22% from June 31, 2011 and $10.4 million or 10% from the previous quarter ended March 31, 2012. We have experienced sequential quarterly declines in each quarter since June 30, 2011. Approximately $61.5 million or 90% of the total classified loans at June 30, 2012 were related to commercial real estate loans in our market area. Several of the non-performing loans that were added during 2012 were adequately collateralized and therefore did not require additional reserves. Classified consumer loans totaled $1.0 million, classified mortgage loans totaled $4.7 million and classified commercial loans totaled $1.4 million. The change in our level of allowance for loan losses is a result of a consistent allowance methodology that is driven by risk ratings. For more information on collection efforts, evaluation of collateral and how loss amounts are estimated, see “Non-Performing Assets,” below.

Although we may allocate a portion of the allowance to specific loans or loan categories, the entire allowance is available for active charge-offs. We develop our allowance estimates based on actual loss experience adjusted for current economic conditions. Allowance estimates represent a prudent measurement of the risk in the loan portfolio, which we apply to individual loans based on loan type. If economic conditions continue to put stress on our borrowers going forward, this may require higher provisions for loan losses in future periods. Credit quality will continue to be a primary focus during 2012 and going forward.

53

Non-Performing Assets

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

Loans that have been restructured are generally placed on nonaccrual status until we determine the future collection of principal and interest is reasonably assured, which will require that the borrower demonstrate a period of performance in accordance to the restructured terms of six months or more.

We review our loans on a regular basis and implement normal collection procedures when a borrower fails to make a required payment on a loan. If the delinquency on a mortgage loan exceeds 90 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, we institute measures to remedy the default, including commencing a foreclosure action. We generally charge off consumer loans when management deems a loan uncollectible and any available collateral has been liquidated. We handle commercial business and real estate loan delinquencies on an individual basis. These loans are placed on non-accrual status upon becoming contractually past due 90 days or more as to principal and interest or where substantial doubt about full repayment of principal and interest is evident.

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

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

Real estate owned acquired through foreclosure is recorded at fair value less estimated selling costs at the date of foreclosure. Fair value is based on the appraised market value of the property based on sales of similar assets. The fair value may be subsequently reduced if the estimated fair value declines below the original appraised value. We monitor market information and the age of appraisals on existing real estate owned properties and obtain new appraisals as circumstances warrant. Real estate acquired through foreclosure increased $7.4 million to $36.5 million at June 30, 2012. Real estate acquired through foreclosure includes $12.7 million in land development properties and building lots, which are located primarily in our Jefferson County market. We anticipate that our level of real estate acquired through foreclosure will remain at elevated levels for some period of time as foreclosures reflecting both weak economic conditions and soft commercial real estate values continue. We also have sales contracts in place on nine other real estate owned properties totaling $20.5 million set to close during the third quarter of 2012, indicating a continued interest in our other real estate owned properties. This includes a bulk sale agreement for the sale of properties for an aggregate price of $16.2 million. Approximately $1.1 million of other real estate write downs and the previously mentioned $1.5 million termination fee were recorded during the quarter ended June 30, 2012 as the terms of this agreement were negotiated. All properties held in other real estate owned are listed for sale with various independent real estate agents.

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A summary of the real estate acquired through foreclosure activity at the period ends is as follows:

	June 30,			December 31,
(Dollars in thousands)	2012			2011
Beginning balance	$	29,083		$	25,807
Additions		15,361			19,416
Sales		(4,372	)		(6,877	)
Writedowns		(3,543	)		(9,263	)
Ending balance	$	36,529		$	29,083

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

	June 30,			March 31,			December 31,			September 30,			June 30,
(Dollar in thousands)	2012			2012			2011			2011			2011
Restructured on non-accrual status	$	21,844		$	18,574		$	18,032		$	23,302		$	12,846
Past due 90 days still on accrual		-			-			-			-			-
Loans on non-accrual status		16,217			20,946			21,718			28,155			24,040
Total non-performing loans		38,061			39,520			39,750			51,457			36,886
Real estate acquired through foreclosure		36,529			30,081			29,083			29,180			26,459
Other repossessed assets		30			49			42			36			34
Total non-performing assets	$	74,620		$	69,650		$	68,875		$	80,673		$	63,379
Interest income that would have
been earned on non-performing loans	$	2,082		$	2,197		$	2,238		$	2,866		$	2,080
Interest income recognized
on non-performing loans		1,035			899			904			940			642
Ratios:  Non-performing loans to total loans (includes loans held for sale in probable branch divestiture)		5.97	%		5.72	%		5.39	%		6.72	%		4.61	%
Non-performing assets to total loans (includes loans held for sale in probable branch divestiture)		11.71	%		10.08	%		9.34	%		10.54	%		7.93	%

Non-performing loans decreased $1.7 million at June 30, 2012 compared to December 31, 2011. The decrease for 2012 was the result of a decrease in non-accrual loans of $5.5 million offset by an increase in restructured non-accruing mortgage, commercial and commercial real estate loans of $3.8 million. Loans that have been restructured are generally placed on nonaccrual status until we determine the future collection of principal and interest is reasonably assured, which will require that the borrower demonstrate improved financial position and a period of performance in accordance to the restructured terms of six months or more. The change in non-accrual loans resulted from the addition of seven non-accrual relationships totaling $8.8 million. Offsetting this increase was a decrease in non-accrual loans due to write-downs of $3.0 million based upon updated appraisals and transfers of seven non-accrual relationships totaling $11.6 million to real estate acquired through foreclosure. A concentration in loans for residential subdivision development in Jefferson and Oldham Counties contributed significantly to the increases in our non-performing loans and our non-performing assets during the past three years. At June 30, 2012, substantially all of our residential housing development assets in these counties have been classified as impaired and written down to what we believe to be at or near liquidation value. The remaining residential development credits are smaller and have strong guarantors. All non-performing loans are considered impaired.

The following table provides information with respect to restructured loans for the periods indicated.

	June 30,		December 31,
(Dollar in thousands)	2012		2011
Restructured loans on non-accrual	$	21,844	$	18,032
Restructured loans on accrual		10,116		16,047
Total restructured loans	$	31,960	$	34,079

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The increase in restructured loans on non-accrual for 2012 resulted from the transfer of a commercial real estate loan relationship totaling $10.1 million that had previously been restructured on accrual. Offsetting this increase was the transfer of one non-accrual relationship totaling $4.9 million to real estate acquired through foreclosure and the transfer of one non-accrual relationship of $1.2 million to accrual status. Five commercial real estate relationships totaling $2.9 million were added to restructured loans on accrual. The loans were evaluated as impaired loans and appropriately allocated specific reserve allowances.

The terms of our restructured loans have been renegotiated to reduce the rate of interest or extend the term, thus reducing the amount of cash flow required from the borrower to service the loans. We anticipate that our level of restructured loans will continue to increase as we identify borrowers in financial difficulty and work with them to modify to more affordable terms. We have worked with customers when feasible to establish “A” and “B” note structures. The “B” note is charged-off on our books but remains an outstanding balance for the customer. These typically carry a very nominal or low rate of interest. The “A” note is a note structured on a proper basis meeting internal policy standards for a performing loan. After six months of performance, the “A” note restructured loan is eligible to be placed back on an accrual basis as a performing troubled debt restructured loan.

Investment Securities

Interest on securities provides us our largest source of interest income after interest on loans, constituting 16.8% of the total interest income for the six months ended June 30, 2012. The securities portfolio serves as a source of liquidity and earnings, and contributes to the management of interest rate risk. We have the authority to invest in various types of liquid assets, including short-term United States Treasury obligations and securities of various federal agencies, obligations of states and political subdivisions, corporate bonds, certificates of deposit at insured savings and loans and banks, bankers’ acceptances, and federal funds. We may also invest a portion of our assets in certain commercial paper and corporate debt securities. We are also authorized to invest in mutual funds and stocks whose assets conform to the investments that we are authorized to make directly. The available-for-sale investment portfolio increased by $3.5 million due to the purchase of government-sponsored mortgage-backed securities offset by the sales of lower yielding investments. Recent purchases have been high cash flow instruments with short average lives in order to decrease the volatility of the investment portfolio as well as provide cash flow in order to limit interest rate risk.

We evaluate investment securities with significant declines in fair value on a quarterly basis to determine whether they should be considered other-than-temporarily impaired under current accounting guidance, which generally provides that if a security is in an unrealized loss position, whether due to general market conditions or industry or issuer-specific factors, the holder of the securities must assess whether the impairment is other-than-temporary. We consider the length of time and the extent to which the fair value has been less than cost, the financial condition and near-term prospects of the issuer, and whether management has the intent to sell the debt security or whether it is more likely than not that we will be required to sell the debt security before its anticipated recovery. In analyzing an issuer’s financial condition, we may consider whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and the results of reviews of the issuer’s financial condition.

The unrealized losses on our government sponsored mortgage-backed residential securities and corporate bonds were a result of changes in interest rates for fixed-rate securities where the interest rate received is less than the current rate available for new offerings of similar securities. Because the decline in market value is attributable to changes in interest rates and not credit quality, and because we do not intend to sell and it is more likely than not that we will not be required to sell these investments until recovery of fair value, which may be maturity, we do not consider these investments to be other-than-temporarily impaired at June 30, 2012.

We have evaluated the decline in the fair value of our trust preferred securities, which are directly related to the credit and liquidity crisis that the financial services industry has experienced in recent years.   The trust preferred securities market is currently inactive, making the valuation of trust preferred securities very difficult.  We value trust preferred securities using unobservable inputs through a discounted cash flow analysis as permitted under current accounting guidance and using the expected cash flows appropriately discounted using present value techniques.   Refer to Note 9 – Fair Value for more information.

We recognized other-than-temporary impairment charges of $26,000 for the expected credit loss during the 2012 period and $2.1 million during the time we have held these securities on five of our trust preferred securities with an original cost basis of $3.0 million. All of our trust preferred securities are currently rated below investment grade. One of our trust preferred securities continues to pay interest as scheduled through June 30, 2012, and is expected to continue paying interest as scheduled. The other four trust preferred securities are paying either partial or full interest in kind instead of full cash interest. Preferred Term Security VI was called for early redemption in July 2012. We received principal and interest of $209,000 and recorded a gain on sale of $192,000. See Note 3 – Securities for more information.  Management will continue to evaluate these securities for impairment quarterly. 

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Deposits

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

Total deposits decreased $33.5 million compared to December 31, 2011. Offsetting this decrease were increases in non-interest bearing, NOW demand and savings deposits compared to December 31, 2011. Public funds decreased $12.6 million while retail and commercial deposits decreased $7.6 million. Brokered deposits and Certificate of Deposits Account Registry Service (“CDARS”) certificates decreased $13.3 million. Brokered deposits were $75.4 million at June 30, 2012 compared to $87.3 million at December 31, 2011. As a result of our Consent Order with bank regulatory agencies, we are no longer allowed to accept, renew or rollover brokered deposits (including deposits through the CDARs program) without prior regulatory approval. Additionally, in 2012 we became a member of Quickrate, a premier non-brokered market place that we use as an additional low cost funding source. We do not anticipate a negative impact as a result of not being able to renew the $75.4 million of brokered deposits due to additional funding sources such as Qwickrate, decreased loan generation, continued loan pay downs, and our highly liquid and mostly short-term investment portfolio.

We have deployed additional resources to try to reduce our cost of funds in this low rate environment. The Consent Order resulted in the Bank being categorized as a “troubled institution” by bank regulators and as a result limits the interest rate the Bank can pay on interest bearing deposits. Unless the Bank is granted a waiver because it resides in a market that the FDIC determines is a high rate market, the Bank is limited to paying deposit interest rates .75% above the average rates computed by the FDIC. The Bank has applied and has been granted the waiver for 2012. However, the Bank has elected to adhere to average rates computed by the FDIC plus the .75% rate cap.

The following table breaks down our deposits.

	June 30,		December 31,
	2012		2011
	(In Thousands)
Non-interest bearing	$	82,596	$	77,629
NOW demand		168,947		160,722
Savings		96,867		91,774
Money market		138,246		138,973
Certificates of deposit		602,646		653,696
	$	1,089,302	$	1,122,794

Non-interest bearing deposits at June 30, 2012 include $13.4 million in deposits held for sale compared to $5.0 million held for sale at December 31, 2011. NOW demand, savings, money market and certificate of deposit balances at June 30, 2012 include $312.2 million in deposits held for sale compared to $112.3 million at December 31, 2011. We have public funds deposits from school boards, water districts and municipalities within our markets. These deposits are larger than individual retail depositors. We do not have a deposit relationship that is significant enough to cause a negative impact on our liquidity position.

Advances from Federal Home Loan Bank

Deposits are the primary source of funds for our lending and investment activities and for our general business purposes. We can also use advances (borrowings) from the Federal Home Loan Bank of Cincinnati (FHLB) to compensate for reductions in deposits or deposit inflows at less than projected levels. At June 30, 2012 we had $27.7 million in advances outstanding from the FHLB. At June 30, 2012, we had sufficient collateral available to borrow, approximately, an additional $14.9 million in advances from the FHLB. Advances from the FHLB are secured by our stock in the FHLB, certain securities and substantially all of our first mortgage loans.

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Subordinated Debentures

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

In 2007, a different trust subsidiary issued 30 year cumulative trust preferred securities totaling $10 million at a 10 year fixed rate of 6.69% adjusting quarterly thereafter at LIBOR plus 160 basis points. The subordinated debentures, which mature March 22, 2037, can be called at par in whole or in part on or after March 15, 2017. We have the option to defer interest payments on the subordinated debt from time to time for a period not to exceed five consecutive years. The subordinated debentures are considered as Tier I capital for the Corporation under current regulatory guidelines.

Our trust subsidiaries loaned the proceeds of their offerings of trust preferred securities to us in exchange for junior subordinated deferrable interest debentures. We are not considered the primary beneficiary of these trusts which are variable interest entities. Therefore the trusts are not consolidated in our financial statements, but rather the subordinated debentures are shown as a liability. Our investment in the common stock of the trusts was $310,000.

On October 29, 2010, we exercised our right to defer regularly scheduled interest payments on both issues of junior subordinated notes relating to outstanding trust preferred securities. Together, the junior subordinated notes had an outstanding principal amount of $18 million. We have the right to defer payments of interest for up to 20 consecutive quarterly periods without default or penalty. After such period, we must pay all deferred interest and resume quarterly interest payments or we will be in default. During the deferral period, the statutory trusts, which are wholly owned subsidiaries of First Financial Service Corporation formed to issue the trust preferred securities, will likewise suspend the declaration and payment of dividends on the trust preferred securities. The regular scheduled interest payments will continue to be accrued for payment in the future and reported as an expense for financial statement purposes. As of June 30, 2012, these accrued but unpaid interest payments totaled $2.4 million.

LIQUIDITY

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

Our banking centers provide access to retail deposit markets. If large certificate depositors shift to our competitors or other markets in response to interest rate changes, we have the ability to replenish those deposits through alternative funding sources. In addition to maintaining a stable core deposit base, we maintain adequate liquidity primarily through the use of investment securities. Traditionally, we have also borrowed from the FHLB to supplement our funding requirements. At June 30, 2012, we had sufficient collateral available to borrow, approximately, an additional $14.9 million in advances from the FHLB. We believe that we have adequate funding sources through unpledged investment securities, loan principal repayments, investment securities pay downs, and potential asset maturities and sales to meet our foreseeable liquidity requirements.

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

The primary source of funding for the Corporation has been dividends and returns of investment from the Bank. Kentucky banking laws limit the amount of dividends that may be paid to the Corporation by the Bank without prior approval of the KDFI. Under these laws, the amount of dividends that may be paid in any calendar year is limited to current year’s net income, as defined in the laws, combined with the retained net income of the preceding two years, less any dividends declared during those periods. The Bank’s Consent Order with the FDIC and KDFI requires us to obtain the consent of the Regional Director of the FDIC and the Commissioner of the KDFI to declare and pay cash dividends to the Corporation. The Corporation has also entered into a formal agreement with the Federal Reserve to obtain regulatory approval before declaring any dividends. We may not redeem shares or obtain additional borrowings without prior approval. Because of these limitations, consolidated cash flows as presented in the consolidated statements of cash flows may not represent cash immediately available to the Corporation. During the first six months of 2012, the Bank did not declare or pay any dividends to the Corporation. Cash held by the Corporation at June 30, 2012 was $387,000 compared to cash of $554,000 at December 31, 2011.

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CAPITAL

Stockholders’ equity decreased $5.0 million for the period ended June 30, 2012 compared to December 31, 2011, primarily due to a net loss attributable to common shareholders recorded during the period. Our average stockholders’ equity to average assets ratio decreased to 4.31% for the six months ended June 30, 2012 compared to 5.66% for the 2011 period.

On January 9, 2009, we sold $20 million of cumulative perpetual preferred shares, with a liquidation preference of $1,000 per share (the “Senior Preferred Shares”) to the U.S. Treasury under the terms of its Capital Purchase Program. The Senior Preferred Shares constitute Tier 1 capital and rank senior to our common shares. The Senior Preferred Shares pay cumulative dividends at a rate of 5% per year for the first five years and will reset to a rate of 9% per year on January 9, 2014.

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

On October 29, 2010, we gave written notice to the U.S. Treasury that effective with the fourth quarter of 2010, we were suspending the payment of regular quarterly cash dividends on our Senior Preferred Shares. The dividends are cumulative and failure to pay dividends for six quarters would trigger the rights of the holder of our Senior Preferred Shares to appoint representatives to our Board of Directors. The dividends will continue to be accrued for payment in the future and reported as a preferred dividend requirement that is deducted from income to common shareholders for financial statement purposes.

On June 19, 2012, the U.S. Treasury (“Treasury”) notified us that the Company’s Series A Preferred Stock would be included in one of a series of pooled auctions of the securities of financial institutions purchased by Treasury under its Capital Purchase Program, which were scheduled to be conducted in the fall of 2012. Treasury also informed us that we could submit a bid to purchase all of our Series A Preferred Stock in advance of the pooled auction, either by us directly or by one or more qualified investors designated by us. Acceptance of any bid is at the discretion of the Treasury, assuming the bid meets a minimum price established internally by Treasury. Our Board of Directors engaged a financial advisor to assist it in identifying, selecting and negotiating with qualified accredited investors regarding the terms of a possible bid. On August 6, 2012, we submitted to Treasury a bid by a group of investors designated by us. Treasury has acknowledged receipt of the bid, which is currently under review. If Treasury accepts the bid and completes a sale to the bidders, the full $20 million stated value of our Series A Preferred Stock would remain outstanding and our obligation to pay dividends, currently at an annual rate of 5% and increasing to 9% in January 2014, would continue until the securities are retired. If the bid is not accepted, Treasury has the option to give us and our designated bidders an opportunity to negotiate a higher purchase price or to include our Series A Preferred Stock in a future pooled or individual auction.

In addition to our agreement with the Federal Reserve that requires prior written consent to repurchase common shares, the terms of our Senior Preferred Shares do not allow us to repurchase shares of our common stock without the consent of the holder until the Senior Preferred Shares are redeemed. During the first six months of 2012, we did not purchase any shares of our common stock.

Each of the federal bank regulatory agencies has established minimum leverage capital requirements for banks. Banks must maintain a minimum ratio of Tier 1 capital to adjusted average quarterly assets ranging from 3% to 5%, subject to federal bank regulatory evaluation of an organization’s overall safety and soundness.

In its 2012 Consent Order with the FDIC and KDFI, the Bank has agreed to achieve and maintain a Tier 1 capital ratio of 9.0% and a total risk-based capital ratio of 12.0% by June 30, 2012. We were not in compliance with the Tier 1 and total risk-based capital requirements at June 30, 2012. We notified the bank regulatory agencies that the increased capital levels would not be achieved. We anticipate that the FDIC and KDFI will reevaluate our progress toward achieving the higher capital ratios at September 30, 2012.

The 2012 Consent Order requires that if the Bank should be unable to reach the required capital levels by June 30, 2012, and the Bank receives written directions from the FDIC and KDFI to do so, then the Bank would develop, adopt and implement within 30 days a written plan to sell or merge itself into another federally insured financial institution. The 2012 Consent Order requires the Bank to continue to adhere to the plans implemented in response to the 2011 Consent Order, and includes the substantive provisions of the 2011 Consent Order. They are working on various specific initiatives to increase our regulatory capital and to reduce our total assets such as the sale of branch offices. We have also provided them with the pro forma information regarding Tier 1 and total risk based capital which we are projecting to be over 8.50% and 12.00%, respectively, based on June 30, 2012 information and on the consummation of the branch sales.

In response to the 2011 Consent Order, we engaged an investment banking firm with expertise in the financial services sector to assist with a review of all of our strategic alternatives as we work to achieve the higher regulatory capital ratios.

We have successfully executed the sale of our four Indiana banking centers to First Savings Bank, F.S.B. The sale of the four retail banking centers, which are located in Corydon, Elizabeth, Lanesville and Georgetown, Indiana, became effective after the close of business on July 6, 2012. We received a 3.65% percent premium on the $102.3 million of consumer and commercial deposits at closing. They assumed a total of approximately $115.4 million in non-brokered deposits, which included $13.1 million of government, corporate, other financial institution and municipal deposits for which we received zero premium or discount. We also sold approximately $30.4 million in performing loans at a discount of 0.80%. The consummated transaction resulted in a one-time gain of approximately $2.9 million.

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On May 15, 2012, we entered into a Branch Purchase Agreement with First Security Bank of Owensboro, Inc., the banking subsidiary of First Security, Inc., headquartered in Owensboro, Kentucky. The agreement provides for the sale of our four banking centers in Louisville, Kentucky to First Security. Under the terms of the Agreement, First Security will assume approximately $210.2 million of deposit liabilities. First Security will pay a deposit premium of approximately $2.9 million comprised of a premium of 2.00% on approximately $153.2 million of deposits and a premium ranging from 0% to 1.00% on approximately $57.0 million of other deposits. First Security will also assume performing loans related to the four branches at a 1.00% discount. The loans being assumed totaled approximately $70.9 million at June 30, 2012. The sale is expected to be completed in the third quarter of 2012 subject to First Security raising additional capital, regulatory approval and other customary closing conditions.

The divestiture of our Indiana franchise, combined with the impending sale of our four Louisville banking centers, is projected to increase our Tier I capital ratio from 5.73% to over 8.50% and increase our total risk-based capital ratio from 10.68% to over 12.00% based on June 30, 2012 financial information. The sale of our four Louisville banking centers is expected to close late in the third quarter of 2012.

The following table shows the ratios of Tier 1 capital, total capital to risk-adjusted assets and the leverage ratios for the Corporation and the Bank as of June 30, 2012.

	Capital Adequacy Ratios as of
	June 30, 2012
	Regulatory
Risk-Based Capital Ratios	Minimums			The Bank			The Corporation
Tier 1 capital		4.00	%		9.42	%		8.89	%
Total risk-based capital		8.00	%		10.68	%		10.16	%
Tier 1 leverage ratio		4.00	%		5.73	%		5.43	%

The 2012 Consent Order requires the Bank to achieve the minimum capital ratios presented below by June 30 2012:

	Actual as of			Ratio Required
	6/30/2012			by Consent Order
Total capital to risk-weighted assets		10.68	%		12.00	%
Tier 1 capital to average total assets		5.73	%		9.00	%

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Asset/Liability Management and Market Risk

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

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

Our interest sensitivity profile was asset sensitive at June 30, 2012 and December 31, 2011. Given a sustained 100 basis point decrease in rates, our base net interest income would decrease by an estimated 9.75% at June 30, 2012 compared to a decrease of 2.39% at December 31, 2011. Given a sustained 100 basis point increase in interest rates, our base net interest income would increase by an estimated 6.57 % at June 30, 2012 compared to an increase of .60% at December 31, 2011.

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Our interest sensitivity at any point in time will be affected by a number of factors. These factors include the mix of interest sensitive assets and liabilities, their relative pricing schedules, market interest rates, deposit growth, loan growth, decay rates and prepayment speed assumptions.

We use various asset/liability strategies to manage the re-pricing characteristics of our assets and liabilities designed to ensure that exposure to interest rate fluctuations is limited within our guidelines of acceptable levels of risk-taking. As demonstrated by the June 30, 2012 and December 31, 2011 sensitivity tables, our balance sheet has an asset sensitive position. This means that our earning assets, which consist of loans and investment securities, will change in price at a faster rate than our deposits and borrowings. Therefore, if short term interest rates increase, our net interest income will increase. Likewise, if short term interest rates decrease, our net interest income will decrease.

Our sensitivity to interest rate changes is presented based on data as of June 30, 2012 and December 31, 2011 annualized to a one year period.

	June 30, 2012
	Decrease in Rates								Increase in Rates
	200			100					100			200
(Dollars in thousands)	Basis Points			Basis Points			Base		Basis Points			Basis Points
Projected interest income
Loans	$	35,575		$	37,245		$	39,260	$	41,145		$	42,908
Investments		6,739			7,016			8,790		11,193			12,941
Total interest income		42,314			44,261			48,050		52,338			55,849
Projected interest expense
Deposits		12,520			12,525			13,141		15,293			17,464
Borrowed funds		2,376			2,376			2,376		2,376			2,376
Total interest expense		14,896			14,901			15,517		17,669			19,840
Net interest income	$	27,418		$	29,360		$	32,533	$	34,669		$	36,009
Change from base	$	(5,115	)	$	(3,173	)			$	2,136		$	3,476
% Change from base		(15.72	)%		(9.75	)%				6.57	%		10.68	%

	December 31, 2011
	Decrease in Rates								Increase in Rates
	200			100					100			200
(Dollars in thousands)	Basis Points			Basis Points			Base		Basis Points			Basis Points
Projected interest income
Loans	$	41,543		$	42,096		$	43,025	$	43,998		$	45,002
Investments		7,183			7,237			7,505		8,269			9,019
Total interest income		48,726			49,333			50,530		52,267			54,021
Projected interest expense
Deposits		13,910			14,047			14,414		15,940			16,156
Borrowed funds		1,354			1,354			1,354		1,355			1,356
Total interest expense		15,264			15,401			15,768		17,295			17,512
Net interest income	$	33,462		$	33,932		$	34,762	$	34,972		$	36,509
Change from base	$	(1,300	)	$	(830	)			$	210		$	1,747
% Change from base		(3.74	)%		(2.39	)%				0.60	%		5.03	%

During the second quarter of 2012 we conservatively revised some of our interest rate risk assumptions and measures resulting in an increased exposure to net interest income in a decreased rate environment, mainly due to a decrease in total interest income when compared to December 31, 2011.  

In an increased rate environment, net interest income at risk, in terms of dollars remained relatively stable as of June 30, 2012 when compared to December 31, 2011. The increase in percentage change from base during this period is due to a decrease in base at June 30, 2012 when compared to December 31, 2011.

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Item 4. CONTROLS AND PROCEDURES

Management is responsible for establishing and maintaining effective disclosure controls and procedures, as defined under Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934. As of June 30, 2012, an evaluation was performed under the supervision and with the participation of management, including the Principal Executive Officer and Principal Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on that evaluation, for the reasons described below, management and the Risk Management Committee of our Board of Directors determined that our internal controls were not effective.

Management is responsible for establishing and maintaining adequate internal controls over financial reporting that are designed to produce reliable financial statements in accordance with accounting principles generally accepted in the United States. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

During our December 31, 2011 review of the allowance for loan loss, the following controls were found to not be operating appropriately:

· Review over internal evaluations for impaired loans

· Review of the mathematical accuracy of impaired loan calculations

· Review of present value cash flow analysis performed on troubled debt restructuring calculations.

To remediate this material weakness described above and enhance our internal controls over financial reporting, management initiated significant changes during the first quarter of 2012. The enhanced procedures included:

· An independent review was performed and documented by the Chief Credit Officer on all internal evaluations; and

· An independent review was performed and documented by the finance department to validate the accuracy of the calculation on all impaired loans and to validate the accuracy of all present value cash flow calculations performed on loans classified as troubled debt restructurings.

Notwithstanding the evaluation and initiation of these remediation actions, the identified material weakness in our internal controls over financial reporting will not be considered remediated until the new controls are fully implemented, operate for a sufficient period of time, and are tested and determined by management to be operating effectively.

There were no other changes in our internal control over financial reporting that occurred during the quarter ended June 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Part II - OTHER INFORMATION

Item 1.	Legal Proceedings
	On June 21, 2012, a lawsuit was filed in the Jefferson County Circuit Court, State of Kentucky styled River Glen KHLB, LLC and Keith T. Eberenz vs. First Federal Savings Bank of Elizabethtown, Civil Action No. 12CI03473. The Complaint seeks compensatory and punitive damages, trial by jury, pre-judgment interest, costs including reasonable attorneys’ fees, and further relief.  In the Complaint, the Plaintiff pleads ten claims against First Federal Savings Bank of Elizabethtown, alleging: Fraud (Count I), negligent misrepresentation (Count II), failure to fund KHLB Note (Count III), failure to fund executive suites loan (Count IV), failure to fund tenant improvement loan (Count V), failure to fund capital loan (Count VI), failure to fund new loan note (Count VII), breach of fiduciary duty (Count VIII), breach of duty of good faith and fair dealing (Count IX), and equitable relief (Count X).    First Federal Savings Bank of Elizabethtown filed an answer to Plaintiff’s Complaint and Counterclaim on June 29, 2012 denying the allegations in the Complaint.  The Counterclaim pleads six claims against River Glen KHLB, LLC and Keith T. Eberenz alleging:  judgment for balance due on Promissory note (Count I), enforcement of guaranty contract (Count II), foreclosure of mortgage (Count III), enforcement of assignment of rents (Count IV), appointment of receiver (Count V), and applicable to all counts (Count VI).
	Dover Realty Advisors LLC and Paragon Dover Kentucky, LLC were appointed managers to preserve and manage the property, including the collection of rent, paying operating expenses, property taxes, insurance premiums, utilities, FFSB monthly loan payment, and an escrow fund.First Federal Savings Bank of Elizabethtown intends to vigorously defend this case. Management continues to closely monitor this case, but is unable to estimate, at this time, the possible loss or range of possible loss, if any, that may result from this lawsuit.
Item 1A.	Risk Factors
	There have been no material changes from the risk factors as previously disclosed in our Annual Report on Form 10-K for the year ended December 31, 2011.
Item 2.	Unregistered Sales of Securities and Use of Proceeds
	We did not repurchase any shares of our common stock during the quarter ended June 30, 2012.

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Item 3.	Defaults Upon Senior Securities
	Not Applicable
Item 4.	Mine Safety Disclosures
	Not Applicable
Item 5.	Other Information
	None
Item 6.	Exhibits:

10.1	Branch Purchase Agreement dated as of May 15, 2012, between First Federal Savings Bank of Elizabethtown and First Security Bank of Owensboro, Inc. (incorporated by reference to Exhibit 10.1 to Current Report Form 8-K filed May 21, 2012).
31.1	Certification of Principal Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
32	Certification of Principal Executive Officer and Principal Financial Officer Pursuant to Section 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
101	The following financial information from the Quarterly Report of First Financial Service Corporation on Form 10-Q for the quarter ended June 30, 2012, formatted in XBRL: (i) Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011, (ii) Consolidated Statements of Operations for the three and six months ended June 30, 2012 and 2011, (iii) Consolidated Statements of Comprehensive Income/(Loss) for the three and six months ended June 30, 2012 and 2011, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the six months ended June 30, 2012, (v) Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and 2011, and (vi) Notes to the Unaudited Consolidated Financial Statements.

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FIRST FINANCIAL SERVICE CORPORATION

SIGNATURES

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

Date:  August 14, 2012	By:	/s/ Gregory S. Schreacke
		Gregory S. Schreacke
		President
		Principal Executive Officer
		Duly Authorized Representative

Date:  August 14, 2012	By:	/s/ Frank Perez
		Frank Perez
		Chief Financial Officer
		Principal Financial Officer

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INDEX TO EXHIBITS

Exhibit No.	Description
10.1	Branch Purchase Agreement dated as of May 15, 2012, between First Federal Savings Bank of Elizabethtown and First Security Bank of Owensboro, Inc. (incorporated by reference to Exhibit 10.1 to Current Report Form 8-K filed May 21, 2012).
31.1	Certification of Principal Executive Officer Pursuant to Section 302 of Sarbanes-Oxley Act
31.2	Certification of Principal Financial Officer Pursuant to Section 302 of Sarbanes-Oxley Act
32	Certification of Principal Executive Officer and Principal Financial Officer Pursuant to 18 U.S.C. Section 1350 (As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002)
101	The following financial information from the Quarterly Report of First Financial Service Corporation on Form 10-Q for the quarter ended June 30, 2012, formatted in XBRL: (i) Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011, (ii) Consolidated Statements of Operations for the three and six months ended June 30, 2012 and 2011, (iii) Consolidated Statements of Comprehensive Income/(Loss) for the three and six months ended June 30, 2012 and 2011, (iv) Consolidated Statements of Changes in Stockholders’ Equity for the six months ended June 30, 2012, (v) Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and 2011, and (vi) Notes to the Unaudited Consolidated Financial Statements.

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