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EX-99.2 - FIRST FINANCIAL SERVICE CORPv177373_ex99-2.htm
EX-99.1 - FIRST FINANCIAL SERVICE CORPv177373_ex99-1.htm
EX-31.1 - FIRST FINANCIAL SERVICE CORPv177373_ex31-1.htm
EX-31.2 - FIRST FINANCIAL SERVICE CORPv177373_ex31-2.htm
Washington, D.C.  20549



For the fiscal year ended December 31, 2009

Commission File Number:  0-18832

(Exact name of registrant as specified in its charter)

(State or other jurisdiction of incorporation
(I.R.S. Employer
or organization)
Identification No.)

2323 Ring Road, Elizabethtown, Kentucky
(Address of principal executive offices)
Zip Code

Registrant's telephone number, including area code:   (270) 765-2131

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, par value $1.00 per share
(Title of Class)

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes ¨ No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes ¨ No  x

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 ninety days.  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.  See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

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 ¨  No ¨

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ¨

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

The aggregate market value of the outstanding voting stock held by non-affiliates of the registrant based on a June 30, 2009 closing price of $17.41 as quoted on the NASDAQ Global Market was $67,818,044. Solely for purposes of this calculation, the shares held by directors and executive officers of the registrant and by any stockholder beneficially owning more than 5% of the registrant's outstanding common stock are deemed to be shares held by affiliates.

As of February 26, 2010 there were issued and outstanding 4,717,682 shares of the registrant's common stock.

Portions of the Registrant’s Definitive Proxy Statement for the 2010 Annual Meeting of Shareholders to be held May 19, 2010are incorporated by reference into Part III of this Form 10-K.





Risk Factors
Unresolved Staff Comments
Legal Proceedings
Market Price of and Dividends on the Registrant’s Common Equity,
Related Stockholder Matters and Issuer Purchases of Equity Securities
Selected Financial Data
Management’s Discussion and Analysis of Financial Condition and Results of
Quantitative and Qualitative Disclosures about Market Risk
Financial Statements and Supplementary Data
Changes in and Disagreements with Accountants on Accounting and Financial
Controls and Procedures
ITEM 10.
Directors and Executive Officers of the Registrant
ITEM 11.
Executive Compensation
ITEM 12.
Security Ownership of Certain Beneficial Owners and Management and Related
Stockholder Matters
ITEM 13.
Certain Relationships and Related Transactions
ITEM 14.
Principal Accountant Fees and Services
ITEM 15.
Exhibits and Financial Statement Schedules


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.

ITEM 1.  Business

First Financial Service Corporation was incorporated in August 1989 under Kentucky law and became the holding company for First Federal Savings Bank of Elizabethtown (the “Bank’), effective on June 1, 1990.  Since that date, we have engaged in no significant activity other than holding the stock of the Bank and directing, planning and coordinating its business activities.  Unless the text clearly suggests otherwise, references to "us," "we," or "our" include First Financial Service Corporation and its wholly owned subsidiary, the Bank.  Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank and its subsidiaries.    In 2004 we amended our articles of incorporation to change our name from First Federal Financial Corporation of Kentucky to First Financial Service Corporation.

We are headquartered in Elizabethtown, Kentucky and were originally founded in 1923 as a state-chartered institution and became federally chartered in 1940. In 1987, we converted to a federally chartered savings bank and converted from mutual to stock form.  We are a member of the FHLB of Cincinnati and, since converting to a state charter in 2003, have been subject to regulation, examination and supervision by the FDIC and the KDFI.  Our deposits are insured by the Deposit Insurance Fund and administered by the FDIC.

On June 25, 2008, we expanded our operations into southern Indiana with the acquisition of FSB Bancshares, Inc., the bank holding company for The Farmers State Bank.  The Farmers State Bank had approximately $65.7 million in total assets and $55.8 million in deposits.  The Farmers State Bank had four banking offices in Harrison and Floyd Counties in Indiana, which are adjacent to four Kentucky counties where we currently operate and are part of the Louisville MSA.  Upon completion of the acquisition, these four offices became branches of First Federal Savings Bank.

General Business Overview

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.


Our full complement of lending services includes:

a broad array of residential mortgage products, both fixed and adjustable rate;

consumer loans, including home equity lines of credit, auto loans, recreational vehicle, and other secured and unsecured loans;

specialized financing programs to support community development;

mortgages for multi-family real estate;

commercial real estate loans;

commercial loans to businesses, including revolving lines of credit and term loans;

real estate development;

construction lending; and

agricultural lending.

        We also provide a broad selection of deposit instruments. These include:

multiple checking and NOW accounts for both personal and business accounts;

various savings accounts, including those for minors;

money market accounts;

tax qualified deposit accounts such as Health Savings Accounts and Individual Retirement Accounts; and

a broad array of certificate of deposit products.

        We also support our customers by providing services such as:

acting as a federal tax depository;

providing access to merchant bankcard services;

supplying various forms of electronic funds transfer;

providing debit cards and credit cards; and

providing telephone and Internet banking.

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 and provisions for loan losses.

Market Area

We operate 22 full-service banking centers and a commercial private banking center in eight contiguous counties in central Kentucky along the Interstate 65 corridor and within the Louisville metropolitan area, including southern Indiana.  Our markets range from Metro 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 to Harrison County, Indiana approximately 60 miles northwest of our headquarters.  Our markets are supported by a diversified industry base and have a regional population of over 1 million.  Louisville and Jefferson County comprise the 16th largest city in the United States.  We operate in Hardin, Nelson, Hart, Bullitt, Meade and Jefferson counties in Kentucky and in Harrison and Floyd counties in southern Indiana.  We control in the aggregate over 22% of the deposit market share in our central Kentucky markets outside of Louisville.  Over the past three years, these counties have demonstrated a growth rate in deposits of 13%.  Based on the continued economic slow-down, management anticipates that our markets may not continue to grow at a similar rate experienced over the last few years.  However, we believe we will still be well positioned to benefit from growth in our local markets when the economy rebounds in the future.

Since 2004, we have expanded our presence in the Louisville market, primarily through our commercial lending operations.  In an effort to better serve these customers and to enhance our retail branch network in Louisville, we opened our fourth new full-service state of the art retail facility in the third quarter of 2009. These facilities represent our state of the art prototype branch with a retail-focused design.  This design features an internet café with access to online banking and bill payment services.  Large plasma screens in the lobby provide customers with current news and information about bank products and services as well as upcoming community events.  The facilities are staffed to offer a full range of financial services to the growing retail and commercial customer base. We also opened a commercial private banking office in Louisville during 2007.  It is the first of its type for our company designed to better serve our high net worth commercial customers.  Our acquisition of FSB Bancshares, Inc. has broadened or retail branch network in the Louisville market, which now extends into southern Indiana.  As of the latest June 30, 2009 FDIC data, the Bank is ranked 12th in deposit market shares in the Louisville Metropolitan Statistical Area.  Based on our service-focused operating strategy, we believe we can increase our presence in Louisville, where five large out-of-state holding companies hold the largest deposit market shares.

All of our market areas will likely benefit from the Fort Knox Military Base Realignment passed into law during 2006.  Fort Knox is located in Hardin County, where we have a 24% market share.  With the base realignment, Fort Knox will receive several additional military units including the Light Infantry Brigade Combat Team, the Combat Service Support Units and the Human Resource Command.  These military units will bring an estimated 2,000 additional civilian positions and 2,000 additional military positions with an estimated $300 million in annual payroll to this area beginning in late 2009 through 2011.  Over $900 million in renovations to Fort Knox are planned to accommodate these units, including the construction of approximately 800,000 square feet of office space to house the Human Resource Command.  We anticipate the base realignment will result in substantial growth in the retail, housing, and service industries in our area.   During the second quarter of 2009, we opened a new full-service facility at the main entrance to the Fort Knox Military Base.  We have already experienced commercial loan growth as a result of ongoing development and have active retail and commercial strategies prepared in anticipation of the new personnel arriving in our market area.

General and Operating Strategies

Our operating strategy is to serve the needs and cater to the economic strengths of the local communities in which we operate and 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.

Our growth strategy is focused on a combination of acquisitions and expansion in our existing markets through internal growth as well as establishing new branches when market conditions support such expansion.

Branch Expansion.    Management continues to consider growing markets for branch expansion.  Because of the economic growth in our markets over the past several years, we may consider further branch expansion in our current or surrounding market areas. However, we do not rule out branch expansion in other areas experiencing economic growth.

In May 2009, we opened the Fort Knox banking center, our twenty-first banking center, which expanded our current footprint in Hardin County, Kentucky.  The Fort Knox banking center complements our existing branch located in Radcliff, Kentucky and is located just outside the main entrance to the Fort Knox military base.   We also completed the construction of our twenty-second banking center which opened in July 2009. The branch is located in the Middletown area of Louisville, Kentucky.

Internal Growth.    Management believes that its largest source of internal growth is through our ongoing solicitation program conducted by branch managers and lending officers, followed by referrals from customers. The primary source for referrals is positive customer endorsements regarding our customer service and response time.

Our goal is to maintain a profitable, customer-focused financial institution. We believe that our existing structure, management, data and operational systems are sufficient to achieve further internal growth in asset size, revenues and capital without proportionate increases in operating costs. This growth should also allow us to increase the lending limits, thereby enabling us to increase our ability to serve the needs of existing and new customers. Our operating strategy has always been to provide high quality community banking services to our customers and increase market share through active solicitation of new business, repeat business and referrals from customers, and continuation of selected promotional strategies.

We believe that our banking customers seek a banking relationship with a service-oriented community banking organization. Our operational systems have been designed to facilitate personalized service. Management believes our banking locations have an atmosphere that encourages personalized services and decision-making, plus we are of sufficient financial size to offer broad product lines to meet customers' needs. We also believe that economic expansion in our market areas will continue to contribute to internal growth. Through our primary emphasis on customer service and our management's banking experience, we intend to continue internal growth by attracting customers and primarily focusing on the following:

Products Offered—We offer personal and corporate banking services, mortgage origination, mortgage servicing, personal investment, and financial counseling services as well as internet and telephone banking. We offer a full range of commercial banking services, including cash management and remote deposit, checking accounts, ATM's, checking accounts with interest, savings accounts, money market accounts, certificates of deposit, NOW accounts, Health Savings Accounts, Individual Retirement Accounts, brokerage and residential mortgage services, branch banking, and debit and credit cards. We also offer installment loans, including auto, recreational vehicle, and other secured and unsecured loans sourced directly by our branches. See "Lending Activities" below for a discussion of products we provide to commercial accounts.

Operational Efficiencies—We seek to maximize operational and support efficiencies consistent with maintaining high quality customer service. We share a common information system designed to enhance customer service and improve efficiencies by providing system-wide voice and data communication connections. We have consolidated loan processing, bank balancing, financial reporting, investment management, information systems, payroll and benefit management, loan review, and audits to operate more efficiently.

Marketing Activities—We focus on a proactive solicitation program for new business, as well as identifying and developing products and services that satisfy customer needs. We actively sponsor community events within our branch areas. We believe that active community involvement enhances our reputation and contributes to our long-term success.

Acquisitions.    Management believes that current economic conditions, the consolidation in the banking industries, along with the easing of restrictions on bank branching, increased regulatory burdens, and concerns about technology and marketing are likely to lead owners of community banks and agencies within the Bank’s market areas to explore the possibility of sale or combination with broader-based financial service companies such as ourselves.

In addition, branching opportunities have arisen from time to time as a result of divestiture of branches by large national and regional bank holding companies of certain overlapping branches resulting from consolidations. As a result, branch locations become available for purchase from time to time and we may consider these opportunities if economic conditions are favorable.

Historically, management has been very selective when evaluating a potential acquisition based upon factors such as the operating strategy, market, financial condition, and the culture of the acquisition candidate.  Our most recent acquisition, completed on June 25, 2008, was the acquisition of FSB Bancshares, Inc. and its wholly owned subsidiary, The Farmers State Bank.  The Farmers State Bank had approximately $65.7 million in total assets and $55.8 million in deposits with offices in Harrison and Floyd County, Indiana.  These counties are adjacent to Kentucky counties where we operate and are part of the Louisville MSA.

Lending Activities

Commercial Real Estate & Construction Lending. The largest portion of our lending activity is the origination of commercial loans that are primarily secured by real estate, including construction loans.  We generate loans primarily in our market area. In recent years, we have put greater emphasis on originating loans for small and medium-sized businesses from our various locations.    We make commercial loans to a variety of industries.  Substantially all of the commercial real estate loans we originate have adjustable interest rates with maturities of 25 years or less or are loans with fixed interest rates and maturities of five years or less. At December 31, 2009, we had $627.8 million outstanding in commercial real estate loans. The security for commercial real estate loans includes retail businesses, warehouses, churches, apartment buildings and motels. In addition, the payment experience of loans secured by income producing properties typically depends on the success of the related real estate project and thus may be more vulnerable to adverse conditions in the real estate market or in the economy generally.

Loans secured by multi-family residential property, consisting of properties with more than four separate dwelling units, amounted to $38.6 million of the loan portfolio at December 31, 2009.  These loans are included in the $627.8 million outstanding in commercial real estate loans discussed above.  We generally do not lend above 75% of the appraised values of multi-family residences on first mortgage loans. The mortgage loans we currently offer on multi-family dwellings are generally one or five year ARMs with maturities of 25 years or less.

Construction loans involve additional risks because loan funds are advanced upon the security of the project under construction, which is of uncertain value before the completion of construction.  The uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies make it relatively difficult to evaluate accurately the total loan funds required to complete a project and related loan-to-value ratios. The analysis of prospective construction loan projects requires significantly different expertise from that required for permanent residential mortgage lending.  At December 31, 2009, we had $14.6 million outstanding in construction loans.

Our underwriting criteria are designed to evaluate and minimize the risks of each construction loan. Among other things, we consider evidence of the availability of permanent financing or a takeout commitment to the borrower; the reputation of the borrower and his or her financial condition; the amount of the borrower's equity in the project; independent appraisals and cost estimates; pre-construction sale and leasing information; and cash flow projections of the borrower.

Commercial Business Lending.  The commercial business loan portfolio has grown in recent years as a result of our focus on small business lending.  We make secured and unsecured loans for commercial, corporate, business, and agricultural purposes, including issuing letters of credit and engaging in inventory financing and commercial leasing activities.   Commercial loans generally are made to small-to-medium size businesses located within our defined market area.  Commercial loans generally carry a higher yield and are made for a shorter term than real estate loans. Commercial loans, however, involve a higher degree of risk than residential real estate loans due to potentially greater volatility in the value of the assigned collateral, the need for more technical analysis of the borrower’s financial position, the potentially greater impact that changing economic conditions may have on the borrower’s ability to retire debt, and the additional expertise required for commercial lending personnel.    Commercial business loans outstanding at December 31, 2009, totaled $62.9 million.

Residential Real Estate.  Residential mortgage loans are secured primarily by single-family homes.  The majority of our mortgage loan portfolio is secured by real estate in our markets outside of Louisville and our residential mortgage loans do not have sub-prime characteristics. Fixed rate residential real estate loans we originate have terms ranging from ten to thirty years. Interest rates are competitively priced within the primary geographic lending market and vary according to the term for which they are fixed.  At December 31, 2009, we had $179.0 million in residential mortgage loans outstanding.

We generally emphasize the origination of adjustable-rate mortgage loans ("ARMs") when possible.  We offer seven ARM products with an annual adjustment, which is tied to a national index with a maximum adjustment of 2% annually, and a lifetime maximum adjustment cap of 6%.  As of December 31, 2009, approximately 42.8% of our residential real estate loans were adjustable rate loans with adjustment periods ranging from one to seven years and balloon loans of seven years or less.  The origination of these ARMs can be more difficult in a low interest rate environment where there is a significant demand for fixed rate mortgages.  We limit the maximum loan-to-value ratio on one-to-four-family residential first mortgages to 90% of the appraised value and generally limit the loan-to-value ratio on second mortgages on one-to-four-family dwellings to 90%.

Consumer Lending.  Consumer loans include loans on automobiles, boats, recreational vehicles and other consumer goods, as well as loans secured by savings accounts, home improvement loans, and unsecured lines of credit. As of December 31, 2009, consumer loans outstanding were $111.5 million. These loans involve a higher risk of default than loans secured by one-to-four-family residential loans. We believe, however, that the shorter term and the normally higher interest rates available on various types of consumer loans help maintain a profitable spread between the average loan yield and cost of funds. Home equity lines of credit as of December 31, 2009, totaled $52.3 million.

Our underwriting standards reflect the greater risk in consumer lending than in residential real estate lending.  Among other things, the capacity of individual borrowers to repay can change rapidly, particularly during an economic downturn, collection costs can be relatively higher for smaller loans, and the value of collateral may be more likely to depreciate.  Our Consumer Lending Policy establishes the appropriate consumer lending authority for all loan officers based on experience, training, and past performance for approving high quality loans.  Loans beyond the authority of individual officers must be approved by additional officers, the Executive Loan Committee or the Board of Directors, based on the size of the loan. We require detailed financial information and credit bureau reports for each consumer loan applicant to establish the applicant’s credit history, the adequacy of income for debt retirement, and job stability based on the applicant’s employment records.  Co-signers are required for applicants who are determined marginal or who fail to qualify individually under these standards.  Adequate collateral is required on the majority of consumer loans.  The Executive Loan Committee monitors and evaluates unsecured lending activity by each loan officer.

The indirect consumer loan portfolio is comprised of new and used automobile, motorcycle and all terrain vehicle loans originated on our behalf by a select group of auto dealers within the service area.  Indirect consumer loans are considered to have greater risk of loan losses than direct consumer loans due to, among other things:  borrowers may have no existing relationship with us; borrowers may not be residents of the lending area; less detailed financial statement information may be collected at application; collateral values can be more difficult to determine; and the condition of vehicles securing the loan can deteriorate rapidly.  To address the additional risks associated with indirect consumer lending, the Executive Loan Committee continually evaluates data regarding the dealers enrolled in the program, including monitoring turn down and delinquency rates. All applications are approved by specific lending officers, selected based on experience in this field, who obtain credit bureau reports on each application to assist in the decision.  Aggressive collection procedures encourage more timely recovery of late payments.  At December 31, 2009, total loans under the indirect consumer loan program totaled $36.6 million.

Subsidiary Activities

First Service Corporation of Elizabethtown (“First Service”), our licensed brokerage affiliate, provides investment services to our customers and offers tax-deferred annuities, government securities, mutual funds, and stocks and bonds.  First Service employs four full-time employees.  The net income of First Service was $26,000 for the year ended December 31, 2009.

First Federal Office Park, LLC, holds commercial lots adjacent to our home office on Ring Road in Elizabethtown, that are available for sale. Currently, one of the original nine lots held for sale remains unsold.

We provide title insurance coverage for mortgage borrowers through two subsidiaries:  First Heartland Title, LLC, and First Federal Title Services, LLC. First Heartland Title is a joint venture with a title insurance company in Hardin County and First Federal Title Services is a joint venture with a title insurance company in Louisville.  We hold a 48% interest in First Heartland Title and a 49% interest in First Federal Title Services. The subsidiaries generated $132,000 in income for the year ended December 31, 2009, of which our portion was $63,000.

Heritage Properties, LLC, holds real estate acquired through foreclosure which is available for sale.  Currently, forty-one properties valued at $8.4 million are held for sale.


We face substantial competition both in attracting and retaining deposits and in lending.  Direct competition for deposits comes from commercial banks, savings institutions, and credit unions located in north-central Kentucky and southern Indiana, and less directly from money market mutual funds and from sellers of corporate and government debt securities.

The primary competitive factors in lending are interest rates, loan origination fees and the range of services offered by the various financial institutions.  Competition for origination of real estate loans normally comes from commercial banks, savings institutions, mortgage bankers, mortgage brokers, and insurance companies.  Retail establishments effectively compete for loans by offering credit cards and retail installment contracts for the purchase of goods, merchandise and services (for example, Home Depot, Lowe’s, etc.).  We believe that we have been able to compete effectively in our primary market area.

We have offices in nine cities in six central Kentucky counties and offices in four cities in two southern Indiana counties.  In addition to the financial institutions with offices in these counties, we compete with several commercial banks and savings institutions in surrounding counties, many of which have assets substantially greater than we have. These competitors attempt to gain market share through their financial product mix, pricing strategies, internet banking and banking center locations.  In addition, Kentucky's interstate banking statute, which permits banks in all states to enter the Kentucky market if they have reciprocal interstate banking statutes, has further increased competition for us.  We believe that competition from both bank and non-bank entities will continue to remain strong in the near future.

The following table shows our market share and rank in terms of deposits as of June 30, 2009, in each Kentucky and Indiana county where we have offices.  We have four offices in Jefferson County, which is Louisville, Kentucky.  The Louisville metropolitan area has a population of more than one million.
Number of Offices
FFKY Market Share %

As of December 31, 2009, we had 333 employees, of which 315 were full-time and 18 part-time.  None of our employees are subject to a collective bargaining agreement, and we believe that we enjoy good relations with our personnel.


General Regulatory Matters.  The Bank is a Kentucky chartered commercial bank and are subject to supervision and regulation, which involves regular bank examinations, by both the FDIC and the KDFI.  Our deposits are insured by the FDIC.  Kentucky’s banking statutes contain a “super-parity” provision that permits a well-rated Kentucky bank to engage in any banking activity in which a national bank operating in any state, a state bank, thrift or savings bank operating in any other state, or a federally chartered thrift or federal savings association meeting the qualified thrift lender test and operating in any state could engage, provided the Kentucky bank first obtains a legal opinion specifying the statutory or regulatory provisions that permit the activity.

In connection with our conversion, we registered to become a bank holding company under the Bank Holding Company Act of 1956, and are subject to supervision and regulation by the Federal Reserve Board.  As a bank holding company, we are required to file with the Federal Reserve Board annual and quarterly reports and other information regarding our business operations and the business operations of our subsidiaries.  We are also subject to examination by the Federal Reserve Board and to its operational guidelines. We are subject to the Bank Holding Company Act and other federal laws and regulations on the types of activities in which we may engage, and to other supervisory requirements, including regulatory enforcement actions for violations of laws and regulations.

Acquisitions and Change in Control.  As a bank holding company, we must obtain Federal Reserve Board approval before acquiring, directly or indirectly, ownership or control of more than 5% of the voting stock of a bank, and before engaging, or acquiring a company that is not a bank but is engaged in certain non-banking activities.  In approving these acquisitions, the Federal Reserve Board considers a number of factors, and weighs the expected benefits to the public such as greater convenience, increased competition and gains in efficiency, against the risks of possible adverse effects such as undue concentration of resources, decreased or unfair competition, conflicts of interest or unsound banking practices.  The Federal Reserve Board also considers the financial and managerial resources of the bank holding company, its subsidiaries and any company to be acquired, and the effect of the proposed transaction on these resources.  It also evaluates compliance by the holding company's financial institution subsidiaries and the target institution with the Community Reinvestment Act.  The Community Reinvestment Act generally requires each financial institution to take affirmative steps to ascertain and meet the credit needs of its entire community, including low and moderate income neighborhoods.

Federal law also prohibits a person or group of persons from acquiring “control” of a bank holding company without notifying the Federal Reserve Board in advance, and then only if the Federal Reserve Board does not object to the proposed transaction.  The Federal Reserve Board has established a rebuttable presumptive standard that the acquisition of 10% or more of the voting stock of a bank holding company would constitute an acquisition of control of the bank holding company.  In addition, any company is required to obtain the approval of the Federal Reserve Board before acquiring 25% (5% in the case of an acquirer that is a bank holding company) or more of any class of a bank holding company’s voting securities, or otherwise obtaining control or a “controlling influence” over a bank holding company.

Other Financial Activities.  The Gramm-Leach-Bliley Act of 1999 permits a bank holding company to elect to become a financial holding company, which permits the holding company to conduct activities that are “financial in nature.”  To become and maintain its status as a financial holding company, the bank holding company and all of its affiliated depository institutions must be well-capitalized, well managed, and have at least a satisfactory Community Reinvestment Act rating. We have not filed an election to become a financial holding company.

Other Holding Company Regulations.  Federal law substantially restricts transactions between financial institutions and their affiliates.  As a result, a bank is limited in extending credit to its holding company (or any non-bank subsidiary), in investing in the stock or other securities of the bank holding company or its non-bank subsidiaries, and/or in taking such stock or securities as collateral for loans to any borrower.  Moreover, transactions between a bank and a bank holding company (or any non-bank subsidiary) must generally be on terms and under circumstances at least as favorable to the bank as those prevailing in comparable transactions with independent third parties or, in the absence of comparable transactions, on terms and under circumstances that in good faith would be available to nonaffiliated companies.

Under Federal Reserve Board policy, a bank holding company is expected to act as a source of financial strength to, and to commit resources to support, its bank subsidiaries. This support may be required at times when, absent such a policy, the bank holding company may not be inclined to provide it. In addition, any capital loans by the bank holding company to its bank subsidiaries are subordinate in right of payment to deposits and to certain other indebtedness of the bank subsidiary.  In the event of a bank holding company's bankruptcy, any commitment by the bank holding company to a federal bank regulatory agency to maintain the capital of subsidiary banks will be assumed by the bankruptcy trustee and entitled to a priority of payment.

Capital Requirements. The Federal Reserve Board and the FDIC have substantially similar risk-based and leverage capital guidelines applicable to the banking organizations they supervise.  Under the risk-based capital requirements, we are generally required to maintain a minimum ratio of total capital to risk-weighted assets (including certain off-balance sheet activities, such as standby letters of credit) of 8%. At least half of the total capital must be composed of common equity, retained earnings and qualifying perpetual preferred stock and certain hybrid capital instruments, less certain intangibles (“Tier 1 capital”). The remainder may consist of certain subordinated debt, certain hybrid capital instruments, qualifying preferred stock and a limited amount of the loan loss allowance (“Tier 2 capital” which, together with Tier 1 capital, composes “total capital”). To be considered well-capitalized under the risk-based capital guidelines, an institution must maintain a total risk-weighted capital ratio of at least 10% and a Tier 1 risk-weighted ratio of 6% or greater. For further information, see “Item 7-Management’s Discussion and Analysis of Financial Condition and Results of Operations-Capital.”

The Federal Deposit Insurance Corporation Act of 1991 (“FDICIA”), among other things, identifies five capital categories for insured depository institutions: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized.  The Corporation and the Bank are classified as “well-capitalized.”  FDICIA also requires the bank regulatory agencies to implement systems for “prompt corrective action” for institutions that fail to meet minimum capital requirements within these five categories, with progressively more severe restrictions on operations, management and capital distributions according to the category in which an institution is placed. Failure to meet capital requirements can also cause an institution to be directed to raise additional capital.  FDICIA also mandates that the agencies adopt safety and soundness standards relating generally to operations and management, asset quality and executive compensation, and authorizes administrative action against an institution that fails to meet such standards.

In addition, the Federal Reserve Board and the FDIC have each adopted risk-based capital standards that explicitly identify concentrations of credit risk and the risk arising from non-traditional activities, as well as an institution’s ability to manage these risks, as important factors to be taken into account by each agency in assessing an institution’s overall capital adequacy. The capital guidelines also provide that an institution’s exposure to a decline in the economic value of its capital due to changes in interest rates be considered by the agency as a factor in evaluating a banking organization’s capital adequacy. In addition to the “prompt corrective action” directives, failure to meet capital guidelines can subject a banking organization to a variety of other enforcement remedies, including additional substantial restrictions on its operations and activities, termination of deposit insurance by the FDIC, and under some conditions the appointment of a conservator or receiver.

Dividends.  The Corporation is a legal entity separate and distinct from the Bank.  The majority of our revenue is from dividends we receive from the Bank.  The Bank is subject to laws and regulations that limit the amount of dividends it can pay. If, in the opinion of a federal regulatory agency, an institution under its jurisdiction is engaged in or is about to engage in an unsafe or unsound practice, the agency may require, after notice and a hearing, that the institution cease and desist from such practice. The federal banking agencies have indicated that paying dividends that deplete an institution's capital base to an inadequate level would be an unsafe and unsound banking practice. Under FDICIA, an insured institution may not pay a dividend if payment would cause it to become undercapitalized or if it already is undercapitalized. Moreover, the Federal Reserve Board and the FDIC have issued policy statements providing that bank holding companies and banks should generally pay dividends only out of current operating earnings.

Under Kentucky law, dividends by Kentucky banks may be paid only from current or retained net profits.  Before any dividend may be declared for any period (other than with respect to preferred stock), a bank must increase its capital surplus by at least 10% of the net profits of the bank for the period until the bank's capital surplus equals the amount of its stated capital attributable to its common stock.  Moreover, the KDFI Commissioner must approve the declaration of dividends if the total dividends to be declared by a bank for any calendar year would exceed the bank's total net profits for such year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt.  We are also subject to the Kentucky Business Corporation Act, which generally prohibits dividends to the extent they result in the insolvency of the corporation from a balance sheet perspective or if becoming unable to pay debts as they come due.


Consumer Protection Laws.  We are subject to a number of federal and state laws designed to protect borrowers and promote lending to various sectors of the economy and population.  These laws include the Equal Credit Opportunity Act, the Fair Credit Reporting Act, the Truth in Lending Act, the Home Mortgage Disclosure Act, and the Real Estate Settlement Procedures Act, and state law counterparts.
Federal law currently contains extensive customer privacy protections provisions.  Under these provisions, a financial institution must provide to its customers, at the inception of the customer relationship and annually thereafter, the institution’s policies and procedures regarding the handling of customers’ nonpublic personal financial information.  These provisions also provide that, except for certain limited exceptions, an institution may not provide such personal information to unaffiliated third parties unless the institution discloses to the customer that such information may be so provided and the customer is given the opportunity to opt out of such disclosure.  Federal law makes it a criminal offense, except in limited circumstances, to obtain or attempt to obtain customer information of a financial nature by fraudulent or deceptive means.
The Community Reinvestment Act (“CRA”) requires the FDIC to assess our record in meeting the credit needs of the communities we serve, including low- and moderate-income neighborhoods and persons.  The FDIC's assessment of our record is made available to the public.  The assessment also is part of the Federal Reserve Board's consideration of applications to acquire, merge or consolidate with another banking institution or its holding company, to establish a new branch office or to relocate an office.  The Federal Reserve Board will also assess the CRA record of the subsidiary banks of a bank holding company in its consideration of any application to acquire a bank or other bank holding company, which may be the basis for denying the application.
Bank Secrecy Act.  The Bank Secrecy Act of 1970 (“BSA”) was enacted to deter money laundering, establish regulatory reporting standards for currency transactions and improve detection and investigation of criminal, tax and other regulatory violations. BSA and subsequent laws and regulations require us to take steps to prevent the use of the Bank in the flow of illegal or illicit money, including, without limitation, ensuring effective management oversight, establishing sound policies and procedures, developing effective monitoring and reporting capabilities, ensuring adequate training and establishing a comprehensive internal audit of BSA compliance activities.
In recent years, federal regulators have increased the attention paid to compliance with the provisions of BSA and related laws, with particular attention paid to “Know Your Customer” practices.  Banks have been encouraged by regulators to enhance their identification procedures prior to accepting new customers in order to deter criminal elements from using the banking system to move and hide illegal and illicit activities.

USA Patriot Act.  The USA PATRIOT Act of 2001 (the “Patriot Act”) contains anti-money laundering measures affecting insured depository institutions, broker-dealers and certain other financial institutions.  The Patriot Act requires financial institutions to implement policies and procedures to combat money laundering and the financing of terrorism, including standards for verifying customer identification at account opening, and rules to promote cooperation among financial institutions, regulators and law enforcement entities in identifying parties that may be involved in terrorism or money laundering.  The Patriot Act also grants the Secretary of the Treasury broad authority to establish regulations and to impose requirements and restrictions on financial institutions’ operations.  In addition, the Patriot Act requires the federal bank regulatory agencies to consider the effectiveness of a financial institution’s anti-money laundering activities when reviewing bank mergers and bank holding company acquisitions.
Federal Deposit Insurance Assessments.  The deposits of our bank subsidiary are insured up to applicable limits by the Deposit Insurance Fund, or the DIF, of the FDIC and are subject to deposit insurance assessments to maintain the DIF. The FDIC utilizes a risk-based assessment system that imposes insurance premiums based upon a risk matrix that takes into account a bank's capital level and supervisory rating.

Effective January 1, 2007, the FDIC imposed deposit assessment rates based on the risk category of the bank subsidiary.  Risk Category I is the lowest risk category while Risk Category IV is the highest risk category.  Because of favorable loss experience and a healthy reserve ratio in the Bank Insurance Fund, or the BIF, of the FDIC, well-capitalized and well-managed banks, have in recent years paid minimal premiums for FDIC insurance. With the additional deposit insurance, a deposit premium refund, in the form of credit offsets, was granted to banks that were in existence on December 31, 1996 and paid deposit insurance premiums prior to that date.  For 2007 and the first half of 2008, our subsidiary bank utilized the credits to offset a majority of its FDIC insurance assessment.

On October 16, 2008, the FDIC published a restoration plan designed to replenish the Deposit Insurance Fund over a period of five years and to increase the deposit insurance reserve ratio, which decreased to 1.01% of insured deposits on June 30, 2008, to the statutory minimum of 1.15% of insured deposits by December 31, 2013.  In order to implement the restoration plan, the FDIC proposes to change both its risk-based assessment system and its base assessment rates.  For the first quarter of 2009 only, the FDIC increased all FDIC deposit assessment rates by 7 basis points. These new rates range from 12 to 14 basis points for Risk Category I institutions to 50 basis points for Risk Category IV institutions.

Under the FDIC's restoration plan, the FDIC proposes to establish new initial base assessment rates that will be subject to adjustment as described below.  Beginning April 1, 2009, the base assessment rates would range from 12 to 16 basis points for Risk Category I institutions to 45 basis points for Risk Category IV institutions.

Changes to the risk-based assessment system would include increasing premiums for institutions that rely on excessive amounts of brokered deposits, increasing premiums for excessive use of secured liabilities (including Federal Home Loan Bank advances), lowering premiums for smaller institutions with very high capital levels, and adding financial ratios and debt issuer ratings to the premium calculations for banks with over $10 billion in assets, while providing a reduction for their unsecured debt.

Either an increase in the Risk Category of the Company’s bank subsidiary or adjustments to the base assessment rates could result in a material increase in our expense for federal deposit insurance.

In addition, all institutions with deposits insured by the FDIC are required to pay assessments to fund interest payments on bonds issued by the Financing Corporation (FICO), a mixed-ownership government corporation established to recapitalize a predecessor to the Deposit Insurance Fund. The current annualized assessment rate is 1.14 basis points, or approximately .285 basis points per quarter. These assessments will continue until the Financing Corporation bonds mature in 2019.

The FDIC implemented a five basis point emergency special assessment on insured depository institutions as of June 30, 2009.  The special assessment was paid on September 30, 2009.  This assessment resulted in a cost of $477,000 and is reflected in our income statement for 2009.  The interim rule also authorizes the FDIC to impose an additional emergency assessment of up to 10 basis points in respect to deposits for quarters ended after June 30, 2009 if necessary to maintain public confidence in federal deposit insurance.  In addition, during the fourth quarter of 2009, the FDIC approved that all banks prepay three and a quarter years worth of FDIC assessments on December 31, 2009.  The prepayment is based on average third quarter deposits.  The prepaid amount will be amortized over the prepayment period.  Our prepayment was $7.5 million of which $494,000 was reflected in our 2009 income statement related to the fourth quarter premium.  

Emergency Economic Stabilization Act.  In October 2008, the Emergency Economic Stabilization Act of 2008 (“EESA”) was enacted. The EESA authorizes the Treasury Department to purchase from financial institutions and their holding companies up to $700 billion in mortgage loans, mortgage-related securities and certain other financial instruments, including debt and equity securities issued by financial institutions and their holding companies in a troubled asset relief program (“TARP”). The purpose of TARP is to restore confidence and stability to the U.S. banking system and to encourage financial institutions to increase their lending to customers and to each other. The Treasury Department has allocated $250 billion towards the TARP Capital Purchase Program (“CPP”). Under the CPP, Treasury has purchased debt or equity securities from participating institutions, including us. The TARP also includes direct purchases or guarantees of troubled assets of financial institutions. Participants in the CPP are subject to executive compensation limits and are encouraged to expand their lending and mortgage loan modifications. For details regarding our sale of $20 million of preferred stock to the Treasury Department through the CPP, see “Item7 Management’s Discussion and Analysis of Financial Condition and Results of Operation Capital and Note 12 of the Notes to Consolidated Financial Statements.”

EESA also increased FDIC deposit insurance on most accounts from $100,000 to $250,000. This increase is in place until December 31, 2013 and is not covered by deposit insurance premiums paid by the banking industry.

Temporary Liquidity Guarantee Program. The FDIC established a Temporary Liquidity Guarantee Program (“TLGP”) on October 14, 2008. The TLGP includes the Transaction Account Guarantee Program (“TAGP”), which provides unlimited deposit insurance coverage through June 30, 2010 for noninterest-bearing transaction accounts (typically business checking accounts) and certain funds swept into noninterest-bearing savings accounts. Institutions participating in the TAGP pay a 10 basis points fee (annualized) on the balance of each covered account in excess of $250,000, while the extra deposit insurance is in place. The TLGP also includes the Debt Guarantee Program (“DGP”), under which the FDIC guarantees certain senior unsecured debt of FDIC-insured institutions and their holding companies. The unsecured debt must be issued on or after October 14, 2008 and not later than October 31, 2009, and the guarantee is effective through the earlier of the maturity date or June 30, 2012. The DGP coverage limit is generally 125% of the eligible entity’s eligible debt outstanding on September 30, 2008 and scheduled to mature on or before June 30, 2009 or, for certain insured institutions, 2% of their liabilities as of September 30, 2008. Depending on the term of the debt maturity, the nonrefundable DGP fee ranges from 50 to 100 basis points (annualized) for covered debt outstanding until the earlier of maturity or June 30, 2012. The TAGP and DGP are in effect for all eligible entities, unless the entity opted out on or before December 5, 2008. First Financial Service Corporation’s bank subsidiary elected to participate in the TAGP and both the bank subsidiary and the holding company are eligible to participate in DGP.

Certificate of Deposit Account Registry Service.  To mitigate the risks associated with carrying balances in excess of federally insured limits, we are participating in the Certificate of Deposit Account Registry Service (“CDARS”).  CDARS is a system that allows certificates of deposit that would be in excess of FDIC coverage in a single financial institution to be redistributed to other financial institutions within the CDARS network in increments under the current FDIC coverage limit.  Consequently, the full amount of the certificates of deposit becomes eligible for FDIC protection.


American Recovery and Reinvestment Act. On February 17, 2009, the American Recovery and Reinvestment Act of 2009 (“ARRA”) was signed into law by President Obama. ARRA includes a wide variety of programs intended to stimulate the economy and provide for extensive infrastructure, energy, health, and education needs. In addition, ARRA imposes certain new executive compensation and corporate expenditure limits on all current and future CPP recipients, including First Financial Service
Corporation, until the institution 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.

Available Information

The periodic reports that we file with the SEC are available at the SEC’s website at  Additionally, all reports we file with the SEC, plus ownership reports filed by our directors and executive officers and additional shareholder information is available free of charge on our website at We post these reports to our website as soon as reasonably practicable after filing them with the SEC.
ITEM 1A.  Risk Factors
The risks identified below, as well as in the other cautionary statements made throughout this report, identify factors that could materially and adversely affect our business, future results of operations, and future cash flows.

Our business has been and may continue to be adversely affected by current conditions in the financial markets and by economic conditions generally.

The capital and credit markets have been experiencing severe recessionary conditions for more than a year.  In some cases, the markets have produced downward pressure on stock prices and credit availability for certain issuers without regard to those issuers’ underlying financial strength.  Reduced consumer spending and the absence of liquidity in the global credit markets during the current recession have depressed business activity across a wide range of industries.  Unemployment has also increased significantly.

Sustained weakness or weakening in business and economic conditions generally or specifically in our markets has had and could continue to have the following adverse effects on our business:

A decrease in the demand for loans and other products and services that we offer;
A decrease in the value of our loans held for sale or other assets secured by consumer or commercial real estate;
An impairment of certain intangible assets;
An increase in the number of clients who become delinquent, file for protection under bankruptcy laws or default on their loans or other obligations to us.

An increase in the number of delinquencies, bankruptcies or defaults has resulted in a higher level of nonperforming assets, net charge-offs, and provision for loan losses.

Overall, during the past year, the general business environment has had an adverse effect on our business, and there can be no assurance that the environment will improve in the near term. Until conditions improve, we expect our businesses, financial condition and results of operations to be adversely affected.

Ongoing market developments may continue to adversely affect our industry, businesses and results of operations.

Since mid-2007, the financial services industry as a whole, as well as the securities markets generally, have been materially and adversely affected by very significant declines in the values of nearly all asset classes and by a very serious lack of liquidity. Financial institutions in particular have been subject to increased volatility and an overall loss in investor confidence.  Concerns about the stability of the financial markets generally and the strength of counterparties have caused many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers including financial institutions.

The lack of available credit, loss of confidence in the financial sector, increased volatility in the financial markets and reduced business activity have materially and adversely affected our business, financial condition and results of operations. Further negative market developments may affect consumer confidence levels and may cause adverse changes in payment patterns, causing increases in delinquencies and default rates, which may impact our charge-offs and provisions for credit losses. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial services industry.


Our decisions regarding credit risk may not be accurate, and our allowance for loan losses may not be sufficient to cover actual losses, which could adversely affect our business, financial condition and results of operations.
We maintain an allowance for loan losses at a level we believe is adequate to absorb any probable incurred losses in our loan portfolio based on historical loan loss experience, specific problem loans, value of underlying collateral and other relevant factors. If our assessment of these factors is ultimately inaccurate, the allowance may not be sufficient to cover actual loan losses, which would adversely affect our operating results. Our estimates are subjective and their accuracy depends on the outcome of future events. Changes in economic, operating and other conditions that are generally beyond our control, including changes in interest rates, could cause actual loan losses to increase significantly. In addition, bank regulatory agencies, as an integral part of their supervisory functions, periodically review the adequacy of our allowance for loan losses.  Regulatory agencies have from time to time required us to increase our provision for loan losses or to recognize further loan charge-offs when their judgment has differed from ours, and may do so in the future, which could have a material negative impact on our operating results.

Our loan portfolio possesses increased risk due to our relatively high concentration of loans collateralized by real estate.

Approximately 87.0% of our loan portfolio as of December 31, 2009 was comprised of loans collateralized by real estate. An adverse change in the economy affecting values of real estate generally or in our primary markets such as we have recently experienced could significantly impair the value of our collateral and our ability to sell the collateral upon foreclosure. The real estate collateral in each case provides an alternate source of repayment in the event of default by the borrower and may deteriorate in value during the time the credit is extended. When real estate values decline, it becomes more likely that we would be required to increase our allowance for loan losses as we did in 2009. If during a period of reduced real estate values we are required to liquidate the collateral securing a loan to satisfy the debt or to increase our allowance for loan losses, it could materially reduce our profitability and adversely affect our financial condition.

Declines in asset values may result in impairment charges and adversely affect the value of our investments, financial performance and capital.

Under U.S. generally accepted accounting principles, we are required to review our investment portfolio periodically for the presence of other-than-temporary impairment of our securities, taking into consideration current market conditions, the extent and nature of change in fair value, issuer rating changes and trends, volatility of earnings, current analysts’ evaluations, our ability and intent to hold investments until a recovery of fair value, as well as other factors. Adverse developments with respect to one or more of the foregoing factors may require us to deem particular securities to be other-than-temporarily impaired, with the reduction in the value recognized as a charge to earnings. Recent market volatility has made it extremely difficult to value certain securities. Subsequent valuations, in light of factors prevailing at that time, may result in significant changes in the values of these securities in future periods. Any of these factors could require us to recognize further impairments in the value of our securities portfolio, which may have an adverse effect on our results of operations in future periods.

Our profitability depends significantly on local economic conditions.

Because most of our business activities are conducted in central Kentucky and adjacent counties of Indiana, and most of our credit exposure is in that region, we are at risk from adverse economic or business developments affecting this area, including declining regional and local business activity, a downturn in real estate values and agricultural activities and natural disasters.  To date, the declines in real estate values in our markets have been moderate compared to the severe declines experienced in other regions.  To the extent the central Kentucky economy further declines, the rates of delinquencies, foreclosures, bankruptcies and losses in our loan portfolio would likely increase. Moreover, the value of real estate or other collateral that secures our loans could be adversely affected by economic downturn or a localized natural disaster. An economic downturn or other events that affect our markets could, therefore, result in losses that may materially and adversely affect our business, financial condition, results of operations and future prospects.

Our small to medium-sized business target market may have fewer resources to weather the downturn in the economy.

Our strategy includes lending to small and medium-sized businesses and other commercial enterprises. Small and medium-sized businesses frequently have smaller market shares than their competitors, may be more vulnerable to economic downturns, often need substantial additional capital to expand or compete and may experience substantial variations in operating results, any of which may impair a borrower’s ability to repay a loan. In addition, the success of a small and medium-sized business often depends on the management talents and efforts of one or two persons or a small group of persons, and the death, disability or resignation of one or more of these persons could have a material adverse impact on the business and its ability to repay our loan. Economic downturns and other events could have a more pronounced negative impact on our target market, which could cause us to incur substantial credit losses that could materially harm our operating results.

Our profitability is vulnerable to fluctuations in interest rates.

Changes in interest rates could harm our financial condition or results of operations.  Our results of operations depend substantially on net interest income, the difference between interest earned on interest-earning assets (such as investments and loans) and interest paid on interest-bearing liabilities (such as deposits and borrowings).  Interest rates are highly sensitive to many factors, including governmental monetary policies and domestic and international economic and political conditions.  Factors beyond our control, such as inflation, recession, unemployment, and money supply may also affect interest rates.  If our interest-earning assets mature or reprice more quickly than our interest-bearing liabilities in a given period, as a result of decreasing interest rates, our net interest income may decrease.  Likewise, our net interest income may decrease if interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period as a result of increasing interest rates.

Fixed-rate loans increase our exposure to interest rate risk in a rising rate environment because interest-bearing liabilities would be subject to repricing before assets become subject to repricing.  Adjustable-rate loans decrease the risk associated with changes in interest rates but involve other risks, such as the inability of borrowers to make higher payments in an increasing interest rate environment.  At the same time, for secured loans, the marketability of the underlying collateral may be adversely affected by higher interest rates.  In the current low interest rate environment, there may be an increase in prepayments on loans as the borrowers refinance their loans at lower interest rates, which could reduce net interest income and harm our results of operations.

We may need to raise additional capital in the future, but that capital may not be available when needed or at all.

We may need to raise additional capital in the future to provide us with sufficient capital resources and liquidity to meet our commitments and business needs. Our ability to raise additional capital, if needed, will depend on, among other things, conditions in the capital markets at that time, which are outside of our control, and our financial performance.  We cannot assure you that capital will be available to us on acceptable terms or at all.  An inability to raise additional capital on acceptable terms when needed could have a materially adverse effect on our businesses, financial condition and results of operations.

If we cannot borrow funds through access to the capital markets, we may not be able to meet the cash flow requirements of our depositors and borrowers, or meet the operating cash needs of the Corporation to fund corporate expansion or other activities.

 Our liquidity policies and limits are established by the Board of Directors, with operating limits set by the Asset Liability Committee (“ALCO”), based upon analyses of the ratio of loans to deposits, the percentage of assets funded with non-core or wholesale funding.  The ALCO regularly monitors the overall liquidity position of the Bank and the Corporation to ensure that various alternative strategies exist to cover unanticipated events that could affect liquidity.  Liquidity is the ability to meet cash flow needs on a timely basis at a reasonable cost.  If our liquidity policies and strategies don’t work as well as intended, then we may be unable to make loans and to repay deposit liabilities as they become due or are demanded by customers.  The ALCO follows established board-approved policies and monitors guidelines to diversify our wholesale funding sources to avoid concentrations in any one-market source.  Wholesale funding sources include Federal funds purchased, securities sold under repurchase agreements, non-core brokered deposits, and medium and long-term debt, which includes Federal Home Loan Bank (“FHLB”) advances that are collateralized with mortgage-related assets.

We maintain a portfolio of securities that can be used as a secondary source of liquidity. There are other available sources of liquidity, including the sale or securitization of loans, the ability to acquire additional non-core brokered deposits, additional collateralized borrowings such as FHLB advances, the issuance of debt securities, and the issuance of preferred or common securities in public or private transactions.  If we were unable to access any of these funding sources when needed, we might not be able to meet the needs of our customers, which could adversely impact our financial condition, our results of operations, cash flows, and our level of regulatory-qualifying capital.  For further discussion, see the “Liquidity” section of Management’s Discussion and Analysis of Financial Condition and Results of Operations.

We face strong competition from other financial institutions and financial service companies, which could adversely affect our results of operations and financial condition.

We compete with other financial institutions in attracting deposits and making loans. Our competition in attracting deposits comes principally from commercial banks, credit unions, savings and loan associations, securities brokerage firms, insurance companies, money market funds and other mutual funds. Competition in making loans in the Louisville metropolitan area has increased in recent years after changes in banking law allowed several banks to enter the market by establishing new branches. Likewise, competition is increasing in our other markets, which may adversely affect our ability to maintain our market share.

Competition in the banking industry may also limit our ability to attract and retain banking clients. We maintain smaller staffs of associates and have fewer financial and other resources than larger institutions with which we compete.  Financial institutions that have far greater resources and greater efficiencies than we do may have several marketplace advantages resulting from their ability to:


offer higher interest rates on deposits and lower interest rates on loans than we can;
offer a broader range of services than we do;
maintain numerous branch locations; and
mount extensive promotional and advertising campaigns.

In addition, banks and other financial institutions with larger capitalization and other financial intermediaries may not be subject to the same regulatory restrictions as we are and may have larger lending limits than we do. Some of our current commercial banking clients may seek alternative banking sources as they develop needs for credit facilities larger than we can accommodate. If we are unable to attract and retain customers, we may not be able to maintain growth and our results of operations and financial condition may otherwise be negatively impacted.

While management continually monitors and improves our system of internal controls, data processing systems, and corporate wide processes and procedures, there can be no assurance that we will not suffer losses from operational risk in the future.

Management maintains internal operational controls and we have invested in technology to help us process large volumes of transactions.  However, there can be no assurance that we will be able to continue processing at the same or higher levels of transactions.  If our systems of internal controls should fail to work as expected, if our systems were to be used in an unauthorized manner, or if employees were to subvert the system of internal controls, significant losses could occur.

We process large volumes of transactions on a daily basis and are exposed to numerous types of operation risk, which could cause us to incur substantial losses.  Operational risk resulting from inadequate or failed internal processes, people, and systems includes the risk of fraud by employees or persons outside of our company, the execution of unauthorized transactions by employees, errors relating to transaction processing and systems, and breaches of the internal control system and compliance requirements.  This risk of loss also includes potential legal actions that could arise as a result of the operational deficiency or as a result of noncompliance with applicable regulatory standards.

We establish and maintain systems of internal operational controls that provide management with timely and accurate information about our level of operational risk.  While not foolproof, these systems have been designed to manage operational risk at appropriate, cost effective levels.  We have also established procedures that are designed to ensure that policies relating to conduct, ethics, and business practices are followed.  Nevertheless, we experience loss from operational risk from time to time, including the effects of operational errors, and these losses may be substantial.

We operate in a highly regulated environment and, as a result, are subject to extensive regulation and supervision that could adversely affect our financial performance and our ability to implement our growth and operating strategies.

We are subject to examination, supervision and comprehensive regulation by federal and state regulatory agencies, which is described under “Item 1 Business – Regulation.”  Regulatory oversight of banks is primarily intended to protect depositors, the federal deposit insurance funds, and the banking system as a whole, not our shareholders. Compliance with these regulations is costly and may make it more difficult to operate profitably.

Federal and state banking laws and regulations govern numerous matters including the payment of dividends, the acquisition of other banks and the establishment of new banking offices. We must also meet specific regulatory capital requirements. Our failure to comply with these laws, regulations and policies or to maintain our capital requirements affects our ability to pay dividends on common stock, our ability to grow through the development of new offices and our ability to make acquisitions.  We currently may not pay a dividend from the Bank to the Corporation without the prior written consent of our primary banking regulators, which limits our ability to pay dividends on our common stock.  These limitations may also prevent us from successfully implementing our growth and operating strategies.

In addition, the laws and regulations applicable to banks could change at any time, which could significantly impact our business and profitability. For example, new legislation or regulation could limit the manner in which we may conduct our business, including our ability to attract deposits and make loans.  Events that may not have a direct impact on us, such as the bankruptcy or insolvency of a prominent U.S. corporation, can cause legislators and banking regulators and other agencies such as the Financial Accounting Standards Board, the SEC, the Public Company Accounting Oversight Board and various taxing authorities to respond by adopting and or proposing substantive revisions to laws, regulations, rules, standards, policies, and interpretations.  The nature, extent, and timing of the adoption of significant new laws and regulations, or changes in or repeal of existing laws and regulations may have a material impact on our business and results of operations.  Changes in regulation may cause us to devote substantial additional financial resources and management time to compliance, which may negatively affect our operating results.


Our issuance of securities to the US Department of the Treasury may limit our ability to return capital to our shareholders and is dilutive to our common shares.  In addition, the dividend rate increases substantially after five years if we cannot  redeem the shares by that time.
On January 9, 2009, as part of the Capital Purchase Program established by the U.S. Department of the Treasury under the Emergency Economic Stabilization Act of 2008 (“EESA”), we sold $20 million of senior preferred stock to the Department of the Treasury.  We also issued to the Department of the Treasury a warrant to purchase approximately 216,000 shares of our common stock at $13.89 per share. The terms of the transaction with the Department of the Treasury limit our ability to pay dividends and repurchase our shares. For three years after issuance or until the Department of the Treasury no longer holds any preferred shares, we will not be able to increase our dividends above the most recent level before October 14, 2008 ($.19 per common share on a quarterly basis) nor repurchase any of our shares without the Department of the Treasury’s approval with limited exceptions, most significantly purchases in connection with benefit plans. Also, we will not be able to pay any dividends at all unless we are current on our dividend payments on the preferred shares. These restrictions, as well as the dilutive impact of the warrant, may have an adverse effect on the market price of our common stock.

Unless we are able to redeem the preferred stock during the first five years, the dividends on this capital will increase substantially at that point, from 5% (approximately $1 million annually) to 9% (approximately $1.8 million annually). Depending on market conditions and our financial performance at the time, this increase in dividends could significantly impact our capital and liquidity.

The US Department of the Treasury has the unilateral ability to change some of the restrictions imposed on us by virtue of our sale of securities to it.

Our agreement with the US Department of the Treasury under which it purchased our securities imposes restrictions on our conduct of our business, including restrictions related to our payment of dividends and repurchase of our stock and related to our executive compensation and governance. The US Department of the Treasury has the right under this agreement to unilaterally amend it to the extent required to comply with any future changes in federal statutes. The American Recovery and Reinvestment Act of 2009 amended provisions of EESA relating to compensation and governance as they affect companies that have sold securities to the US Department of the Treasury. In some cases, these amendments require action by the US Department of the Treasury to implement them. These amendments could have an adverse impact on the conduct of our business, as could additional amendments in the future that impose further requirements or amend existing requirements.

ITEM 1B.   Unresolved Staff Comments

We have no unresolved SEC staff comments.

ITEM 2.     Properties

Our executive offices and principal support are located at 2323 Ring Road in Elizabethtown, Kentucky.  Our operational functions are located at 2323 Ring Road and 101 Financial Place in Elizabethtown, Kentucky.  All of our banking centers are located in Kentucky and Southern Indiana.  The location of our 22 full-service banking centers, an operations building and a commercial private banking center, whether owned or leased, and their respective approximate square footage is described in the following table.

2323 Ring Road
325 West Dixie Avenue
2101 North Dixie Avenue
101 Financial Place
475 West Lincoln Trail
1671 North Wilson Road
401 East John Rowan Blvd.
315 North Third Street
925 Main Street
395 N. Buckman Street
1707 Cedar Grove Road,  Suite 1
279 Bardstown Road
416 East Broadway
50 Old Mill Road
4055 Flaherty Road
11810 Interchange Drive
3650 South Hurstbourne Parkway
12629 Taylorsville Road
4965 U.S. Highway 42, Suite 2100
301 Blakenbaker Parkway
2030 Hwy 337 NW
8160 Beech Street NE
6500 State Road 64
7340 Main Street
ITEM 3.     Legal Proceedings

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

ITEM 4.     Reserved


Market Price of and Dividends on the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

(a)     Market Information

Our common stock is traded on the Nasdaq Global Market (“NASDAQ”) under the symbol “FFKY”.  The following table shows the high and low closing prices of our Common Stock and the dividends paid.
Quarter Ended
  $ 13.71     $ 19.99     $ 17.77     $ 13.06  
    10.00       11.37       13.47       8.24  
Cash dividends
    0.19       0.19       0.05       -  
  $ 24.42     $ 23.96     $ 21.00     $ 20.50  
    20.88       18.14       15.83       10.25  
Cash dividends
    0.19       0.19       0.19       0.19  
(b)      Holders

           At December 31, 2009, the number of shareholders was approximately 1,257.

(c)      Dividends

During the fourth quarter of 2009, we announced the suspension of future cash dividend payments in order to conserve capital and maintain liquidity.  It is unlikely that we will declare or pay any common stock cash dividends in 2010.  Under our agreement with the Treasury Department, until the earlier of January 9, 2012 or until we redeem all of the preferred shares sold under the CPP, we will not be able to increase our dividends above the most recent level ($.19 per common share on a quarterly basis).

First Financial Service Corporation is a Kentucky corporation, and our shareholders are entitled to receive such dividends and other distributions when, as and if declared from time to time by our board of directors out of funds legally available for distributions to shareholders. Any future determinations relating to the payment of dividends will be made at the discretion of our board of directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects and other factors that our board of directors may deem relevant.  As a bank holding company, our ability to declare and pay dividends also depends on federal regulatory considerations, including the guidelines of the Federal Reserve regarding capital adequacy and dividends.

As a bank holding company, our principal source of revenue is the dividends that may be declared from time to time by the Bank out of funds legally available for payment of dividends. Currently, the Bank must obtain the written consent of its primary regulators before declaring or paying any future dividends to the Corporation.  In addition to this current restriction, various banking laws applicable to the Bank limit the payment of dividends to us. A Kentucky chartered bank may declare a dividend of an amount of the bank’s net profits as the board deems appropriate. The approval of the KDFI is required if the total of all dividends declared by the bank in any calendar year exceeds the total of its net profits for that year combined with its retained net profits for the preceding two years, less any required transfers to surplus or a fund for the retirement of preferred stock or debt.


 (d)     Securities Authorized for Issuance Under Equity Compensation Plans
The following table summarizes the securities authorized for issuance under our equity compensation plans as of December 31, 2009.  We have no equity compensation plans that have not been approved by our shareholders.
Number of securities
Number of securities
remaining available for
to be issued
future issuance under
upon exercise of
exercise price of
equity compensation plans
outstanding options,
outstanding options,
(excluding securities
Plan category
warrants and rights
warrants and rights
reflected in column (1))
Equity compensation plans approved by security holders
    279,706     $ 15.12       454,750  
See Note 16 of the Notes to Consolidated Financial Statements for additional information required by this item.

(e)      Issuer Purchases of Equity Securities

We did not repurchase any shares of our common stock during the quarter ended December 31, 2009

(f)      Performance Graph

The graph below compares the cumulative total return on the common stock of the Corporation between December 31, 2004 through December 31, 2009 with the cumulative total return of the NASDAQ Composite Index and a peer group index over the same period.  Dividend reinvestment has been assumed.  The graph was prepared assuming that $100 was invested on December 31, 2004 in the common stock of the Corporation and in the indexes.  The stock price performance shown on the graph below is not necessarily indicative of future stock performance.

ITEM 6.     Selected Consolidated Financial and Other Data
(Dollars in thousands, except per share data)
At December 31,
Financial Condition Data:
Total assets
  $ 1,209,504     $ 1,017,047     $ 872,691     $ 822,826     $ 766,513  
Net loans outstanding (1)
    985,390       899,436       760,114       698,026       635,740  
    46,931       22,797       39,685       52,447       61,555  
    1,049,815       775,399       689,243       641,037       591,106  
    72,245       165,816       105,883       106,724       107,875  
Stockholders' equity
    85,132       72,952       73,460       72,098       64,741  
Number of:
    22       20       15       14       14  
Full time equivalent employees
    324       316       284       270       254  
Year Ended December 31,
Operations Data:
Interest income
  $ 58,856     $ 57,564     $ 60,545     $ 53,832     $ 45,368  
Interest expense
    21,792       24,799       29,751       24,108       17,862  
Net interest income
    37,064       32,765       30,794       29,724       27,506  
Provision for loan losses
    9,524       5,947       1,209       540       1,258  
Non-interest income
    8,519       8,449       8,203       7,739       8,067  
Non-interest expense
    43,917       28,286       23,790       21,952       20,759  
Income tax expense/(benefit)
    (1,149 )     2,184       4,646       4,634       4,412  
Net income/(loss)
    (6,709 )     4,797       9,352       10,337       9,144  
Earnings/(loss) per common share: (2)
    (1.65 )   $ 1.03     $ 1.98     $ 2.14     $ 1.89  
    (1.65 )     1.02       1.96       2.12       1.88  
Book value per common share (2)
    13.87       15.63       15.76       14.95       13.43  
Dividends paid per common share (2)
    0.43       0.76       0.73       0.66       0.59  
Return on average assets
    (.61 )%     0.51 %     1.10 %     1.31 %     1.22 %
Average equity to average assets
    8.56 %     8.02 %     8.54 %     8.71 %     8.33 %
Return on average equity
    (7.18 )%     6.37 %     12.88 %     15.03 %     14.60 %
Efficiency ratio (3)
    70 %     69 %     61 %     59 %     58 %
Includes loans held for sale.
Amounts adjusted to reflect 10% stock dividends declared August 15, 2006, and August 16, 2007.
Excludes goodwill impairment

ITEM 7.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations analyzes the major elements of our balance sheets and statements of operations.  This section should be read in conjunction with our Consolidated Financial Statements and accompanying Notes and other detailed information.
Over the past several years we have focused on enhancing and expanding our retail and commercial banking network in our core markets as well as establishing our presence in the Louisville market.  Our core markets, where we have a combined 22% market share, have become increasingly competitive as several new banks have entered those markets during the past few years.  In order to protect and grow our market share, we are replacing existing branches with newer, enhanced facilities and anticipate constructing new facilities over the next few years.  In addition to the enhancement and expansion in our core markets, we have been increasing our presence in the Louisville market.  Our acquisition of FSB Bancshares, Inc. has broadened our retail branch network in the Louisville market, which now extends into southern Indiana.  Approximately 55% of the deposit base in the Louisville market is controlled by five out-of-state banks.  While the market is very competitive, we believe this creates an opportunity for smaller community banks with more power to make decisions locally.  We believe our investment in these initiatives along with our continued commitment to a high level of customer service will enhance our market share in our core markets and our development in the Louisville market.

Our retail branch network continues to generate encouraging results.  Total deposits have grown 64% over the past three years. Total deposits were $1.0 billion at December 31, 2009, an increase of $274.4 million from December 31, 2008.  After our acquisition of Farmers State Bank in 2008, our retail branch network in the Louisville market has broadened to sixteen offices.  In May 2009, we opened the Fort Knox banking center, our twenty-first banking center, which expanded our current footprint in Hardin County, Kentucky.  The Fort Knox banking center complements our existing branch located in Radcliff, Kentucky and is located just outside the main entrance to the Fort Knox military base.   We also completed the construction of our twenty-second banking center which opened in July 2009. The branch is located in the Middletown area of Louisville, Kentucky.  Competition for deposits continues to be challenging in all of the markets we serve. We believe this intense competition combined with continued re-pricing of variable rate loans could add to additional margin compression.



Our retail branch network continues to generate encouraging results.  Total deposits have grown 64% over the past three years. Total deposits were $1.0 billion at December 31, 2009, an increase of $274.4 million from December 31, 2008.  After our acquisition of Farmers State Bank in 2008, our retail branch network in the Louisville market has broadened to sixteen offices.  In May 2009, we opened the Fort Knox banking center, our twenty-first banking center, which expanded our current footprint in Hardin County, Kentucky.  The Fort Knox banking center complements our existing branch located in Radcliff, Kentucky and is located just outside the main entrance to the Fort Knox military base.   We also completed the construction of our twenty-second banking center which opened in July 2009. The branch is located in the Middletown area of Louisville, Kentucky.  Competition for deposits continues to be challenging in all of the markets we serve. We believe this intense competition combined with continued re-pricing of variable rate loans could add to additional margin compression.

We have developed a strong commercial real estate niche in our markets.  We have an experienced team of bankers who focus on providing service and convenience to our customers.  It is quite common for our bankers to close loans at a customer’s place of business or even the customer’s personal residence.   This high level of service has been well received in our Louisville market, which is dominated by regional banks.  To further develop our commercial banking relationships in Louisville, we opened a private banking office in April 2007.  This upscale facility complements our full service centers in Louisville by attracting commercial deposit relationships in conjunction with our commercial lending relationships.

Our emphasis on commercial lending generated 42% growth in the total loan portfolio and 48% growth in commercial loans over the past three years.  Commercial loans were $705.3 million at December 31, 2009, an increase of $67.7 million, or 10.6% from December 31, 2008.

The 2009 results include goodwill impairment of $11.9 million (related to the January 1995 acquisition of Bullitt Federal Savings Bank, the July 1998 acquisition of three Bank One Corporation branches and the June 2008 acquisition of FSB Bancshares, Inc.).  This impairment loss reflects the results of our impairment testing due to declining market conditions.  While this charge flows through our income statement, it is a non-cash item that does not impact our liquidity or adversely affect regulatory or tangible capital ratios.

Despite the continued adverse economic conditions during 2009, the Corporation’s capital position remained well-capitalized as defined by regulatory standards.  Our capital position was further bolstered in the first quarter of 2009 by our participation in the U.S. Treasury Department Capital Purchase Program (“CPP”).  Under the CPP, we sold $20 million of cumulative perpetual preferred shares to the U.S. Treasury in a transaction that closed on January 9, 2009.

We believe that the current adverse economic conditions will be long lasting.  During the last quarter of 2008, the continued economic slowdown moved to sectors not previously impacted, including consumer, commercial, industrial among others.  Credit issues are broadening in these sectors and economic recovery is most likely several quarters away.  We will continue to monitor credit quality very closely in 2010 as this recession persists.  As the economy and the financial sector continue to struggle, probable losses in the loan portfolio could increase, resulting in higher provision for loan losses during 2010.
Our accounting and reporting policies comply with U.S. generally accepted accounting principles and conform to general practices within the banking industry.  The accounting policy relating to the allowance for loan losses is critical to the understanding of our results of operations since the application of this policy requires significant management assumptions and estimates that could result in materially different amounts to be reported if conditions or underlying circumstances were to change.

Allowance for Loan LossesWe maintain an allowance 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, evaluates the allowance for loan losses on a quarterly basis.  We estimate 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 or loans otherwise classified as substandard or doubtful.  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 $17.7 million or 1.78% of total loans was our estimate of probable losses within the loan portfolio as of December 31, 2009.  This estimate resulted in a provision for loan losses on the income statement of $9.5 million for the 2009 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 be materially increased.



Goodwill and Other Intangible Assets – Costs in excess of the estimated fair value of identified assets acquired through purchase transactions are recorded as an asset. An annual impairment analysis is required to be performed to determine if the asset is impaired and needs to be written down to its fair value. This assessment is conducted annually or more frequently if conditions warrant. In making these impairment analyses, management must make subjective assumptions regarding the fair value of our assets and liabilities. It is possible that these judgments may change over time as market conditions or our strategies change, and these changes may cause us to record impairment changes to adjust the goodwill to its estimated fair value.  Based on the December 31, 2009 analysis, an impairment of $11.9 million was identified.  The impairment charge is a non-cash item that does not impact our liquidity or adversely affect regulatory or tangible capital ratios.

Impairment of Investment SecuritiesWe 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 corresponding charge to earnings is recognized.

Real estate ownedThe 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.
Net loss for the period ended December 31, 2009 was $(6.7) million or $(1.65) per diluted common share compared to net income of $4.8 million or $1.02 per diluted common share for the same period in 2008.  Earnings decreased for 2009 compared to 2008 due to a decrease in our net interest margin, an increase in provision for loan loss expense, write downs taken on investment securities that were other-than-temporarily impaired, write downs taken on real estate acquired through foreclosure, higher FDIC insurance premiums, a goodwill impairment charge and higher operating expenses.  Net income available to common shareholders was also impacted by dividends paid on preferred shares.  Our book value per common share decreased from $15.63 at December 31, 2008 to $13.87 at December 31, 2009.

Net income for the period ended December 31, 2008 was $4.8 million or $1.02 per diluted common share compared to $9.4 million or $1.96 per diluted common share for the same period in 2007.  Earnings decreased for 2008 compared to 2007 due to a decrease in our net interest margin, an increase in provision for loan loss expense, a higher level of non-interest expense related to our expansion efforts, a write down taken on investment securities that were other-than-temporarily impaired and a write down on real estate acquired through foreclosure.  Our book value per common share decreased from $15.76 at December 31, 2007 to $15.63 at December 31, 2008. Net income for 2008 generated a return on average assets of 0.51% and a return on average equity of 6.37%. These compare with a return on average assets of 1.10% and a return on average equity of 12.88% for the 2007 period.

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 growth in our commercial loan portfolio has increased net interest income.  The increase in the volume of interest earning assets increased net interest income by $4.3 million for 2009 compared to a year ago.  Average interest earning assets increased $148.9 million for 2009 compared to 2008.  Despite the increase in interest earning assets, our net interest margin realized a modest decline of twelve basis points.  The yield on earning assets averaged 5.79% for 2009 compared to an average yield on earning assets of 6.63% for the same period in 2008.  This decrease was offset by a decrease in our cost of funds.  Net interest margin as a percent of average earning assets decreased to 3.66% for 2009 compared to 3.78% for the 2008 period.

Our cost of funds averaged 2.33% for the 2009 period compared to an average cost of funds of 3.10% for the same period in 2008. Going forward, our cost of funds is expected to continue to decrease as certificates of deposit re-price and roll off into new certificates of deposit at lower interest rates.



Our net interest margin is likely to compress in future quarters as a result of the FOMC decreasing the Federal Funds rate by 500 basis points since September 2007.  The current Federal Funds rate is a range of 0.00% to 0.25%.  Correspondingly, variable rate loans that are tied to the prime rate are immediately re-priced downward when the prime rate decreases.  However, interest rates paid on customer deposits, which are priced off of the London Interbank Offering Rate (LIBOR), have not adjusted downward proportionately with the declining interest yields on loans and investments.  LIBOR, which is a market driven rate, did not decline in rate as much as the prime rate.  Therefore, we do not expect our deposit costs to decline as fast as our yield on loans.  Fifty-eight percent of deposits are time deposits that re-price over a longer period of time.  This difference in the timing of the re-pricing of our assets and deposits is expected to continue to lower our net interest margin.
Comparative information regarding net interest income follows:
(Dollars in thousands)
Net interest income, tax equivalent basis
  $ 37,326     $ 32,970     $ 31,009       13.2 %       6.3 %  
Net interest spread
    3.46 %     3.53 %     3.53 %     (7 )
Net interest margin
    3.66 %     3.78 %     3.89 %     (12 )
    (11 )
Average earnings assets
  $ 1,020,803     $ 871,940     $ 796,275       17.1 %       9.5 %  
Prime rate at year end
    3.25 %     3.25 %     7.25 %     -  
    (400 )
Average prime rate
    3.25 %     5.09 %     8.05 %     (184 )
    (296 )
bp = basis point = 1/100th of a percent

Prime rate is included above to provide a general indication of the interest rate environment in which we operate.  A large portion of our variable rate loans were indexed to the prime rate and re-price as the prime rate changes, unless they reach a contractual floor or ceiling.




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.

Year Ended December 31,
(Dollars in thousands)
Interest earning assets:
U.S. Treasury and agencies
  $ 11,537     $ 251       2.18 %   $ 6,469     $ 257       3.97 %   $ 18,147     $ 651       3.59 %
Mortgage-backed securities
    6,963       290       4.16 %     9,006       390       4.33 %     11,993       517       4.31 %
Equity securities
    959       106       11.05 %     1,543       67       4.34 %     2,036       75       3.68 %
State and political subdivision securities (1)
    11,848       771       6.51 %     9,426       600       6.37 %     9,935       633       6.37 %
Corporate bonds
    187       117       62.57 %     2,533       159       6.28 %     4,358       307       7.04 %
Loans (2) (3) (4)
    971,750       57,113       5.88 %     830,748       55,739       6.71 %     741,274       58,019       7.83 %
FHLB stock
    8,515       383       4.50 %     8,116       423       5.21 %     7,621       503       6.60 %
Interest bearing deposits
    9,044       87       0.96 %     4,099       134       3.27 %     911       55       6.04 %
Total interest earning assets
    1,020,803       59,118       5.79 %     871,940       57,769       6.63 %     796,275       60,760       7.63 %
Less:  Allowance for loan losses
    (14,972 )                     (9,114 )                     (7,966 )                
Non-interest earning assets
    86,398                       76,343                       61,912                  
Total assets
  $ 1,092,229                     $ 939,169                     $ 850,221                  
Interest bearing liabilities:
Savings accounts
  $ 119,745     $ 905       0.76 %   $ 106,901     $ 1,666       1.56 %   $ 96,221     $ 3,017       3.14 %
NOW and money market accounts
    179,917       1,402       0.78 %     136,796       1,307       0.96 %     123,408       2,166       1.76 %
Certificates of deposit and other time deposits
    515,764       15,610       3.03 %     444,718       17,539       3.94 %     424,603       20,336       4.79 %
Short-term borrowings
    50,602       152       0.30 %     44,454       896       2.02 %     36,782       1,935       5.26 %
FHLB advances
    52,742       2,405       4.56 %     53,009       2,413       4.55 %     34,732       1,580       4.55 %
Subordinated debentures
    18,000       1,318       7.32 %     14,667       978       6.67 %     10,000       717       7.17 %
Total interest bearing liabilities
    936,770       21,792       2.33 %     800,545       24,799       3.10 %     725,746       29,751       4.10 %
Non-interest bearing liabilities:
Non-interest bearing deposits
    58,945                       57,962                       46,343                  
Other liabilities
    3,073                       5,349                       5,508                  
Total liabilities
    998,788                       863,856                       777,597                  
Stockholders' equity
    93,441                       75,313                       72,624                  
Total liabilities and stockholders' equity
  $ 1,092,229                     $ 939,169                     $ 850,221                  
Net interest income
          $ 37,326                     $ 32,970                     $ 31,009          
Net interest spread
                    3.46 %                     3.53 %                     3.53 %
Net interest margin
                    3.66 %                     3.78 %                     3.89 %
Ratio of average interest earning assets to average interest bearing liabilities
                    108.97 %                     108.92 %                     109.72 %

(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.




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.

Year Ended
Year Ended
December 31,
December 31,
2009 vs. 2008
2008 vs. 2007
Increase (decrease)
Increase (decrease)
Due to change in
Due to change in
(Dollars in thousands)
Interest income:
U.S. Treasury and agencies
  $ (150 )   $ 144     $ (6 )   $ 64     $ (458 )   $ (394 )
Mortgage-backed securities
    (14 )     (86 )     (100 )     2       (129 )     (127 )
Equity securities
    72       (33 )     39       12       (20 )     (8 )
State and political subdivision securities
    14       157       171       (1 )     (32 )     (33 )
Corporate bonds
    229       (271 )     (42 )     (148 )     -       (148 )
    (7,409 )     8,783       1,374       (8,825 )     6,545       (2,280 )
FHLB stock
    (60 )     20       (40 )     (111 )     31       (80 )
Interest bearing deposits
    (137 )     90       (47 )     (35 )     114       79  
Total interest earning assets
    (7,455 )     8,804       1,349       (9,042 )     6,051       (2,991 )
Interest expense:
Savings accounts
    (942 )     181       (761 )     (1,655 )     304       (1,351 )
NOW and money market accounts
    (269 )     364       95       (1,073 )     214       (859 )
Certificates of deposit and other time deposits
    (4,466 )     2,537       (1,929 )     (3,724 )     927       (2,797 )
Short-term borrowings
    (853 )     109       (744 )     (1,380 )     341       (1,039 )
FHLB advances
    4       (12