1st Financial Services CORP - FORM 10-Q

Attached files

file	filename
EX-31.2 - CERTIFICATION - 1st Financial Services CORP	ffis_ex312.htm
EX-31.1 - CERTIFICATION - 1st Financial Services CORP	ffis_ex311.htm
EX-32.1 - CERTIFICATION - 1st Financial Services CORP	ffis_ex321.htm

United States

Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-Q

(MARK ONE)

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2011

o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

1ST FINANCIAL SERVICES
CORPORATION

(Exact name of the registrant as specified in its charter)

NORTH CAROLINA		000-53264		26-0207901
(State or other Jurisdiction of incorporation or organization)		(Commission File Number)		(IRS Employer Identification No.)

101 Jack Street

Hendersonville, North Carolina 28792

(Address of Principal Executive Office)

(828) 697-3100

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 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 þ NO o

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 “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer

Accelerated filer

Non-accelerated filer

Smaller reporting company

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES o NO þ

Common Stock, $5 par value

5,168,546 shares outstanding as of August 5, 2011

1st Financial Services Corporation
Index

		Page Number
PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Balance Sheets as of June 30, 2011 (Unaudited) and December 31, 2010.		1
	Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2011 and 2010 (Unaudited)		2
	Consolidated Statements of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2011 and 2010 (Unaudited)		3
	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2011 and 2010 (Unaudited)		4
	Notes to Consolidated Financial Statements (Unaudited)		5-33

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		34-57
Item 3.	Quantitative and Qualitative Disclosures about Market Risk		58
Item 4.	Controls and Procedures		58

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings		59
Item 1A.	Risk Factors		59
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		59
Item 3.	Defaults Upon Senior Securities		59
Item 4.	(Removed and Reserved)		59
Item 5.	Other Information		59
Item 6.	Exhibits		59
	Signatures		60

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

1st Financial Services Corporation
Consolidated Balance Sheets
June 30, 2011 (Unaudited) and December 31, 2010

(dollars in thousands, except share and per share data)	June 30, 2011			December 31, 2010
Assets
Cash and noninterest-bearing bank deposits	$	15,466		$	14,783
Due from Federal Reserve Bank		37,810			36,140
Interest-bearing deposits with banks		6,366			6,475
Total cash and cash equivalents		59,642			57,398
Investment securities available for sale		157,704			130,414
Investment securities held to maturity (fair value of $4,044
at June 30, 2011 and $2,742 at December 31, 2010)		3,964			2,765
Restricted equity securities		4,595			5,516
Loans held for sale		3,746			11,026
Portfolio loans		460,443			486,195
Allowance for loan losses		(11,812	)		(16,191	)
Net portfolio loans		448,631			470,004
Bank-owned life insurance		12,736			12,517
Property and equipment, net		5,398			5,928
Accrued interest receivable		2,437			2,356
Investment in real estate partnership		6,356			6,356
Foreclosed real estate		8,255			7,314
Deferred income taxes		9,588			10,073
Other assets		866			3,137
Total assets	$	723,918		$	724,804

Liabilities and Stockholders’ Equity
Liabilities
Demand deposits	$	71,210		$	65,398
NOW accounts		64,371			66,831
Savings deposits		125,585			111,553
Money market accounts		51,299			48,801
Time deposits under $100		197,846			200,061
Time deposits of $100 and greater		166,644			181,693
Total deposits		676,955			674,337

Federal funds purchased and securities sold under agreements to repurchase		812			704
Accrued interest payable		1,198			1,865
Other borrowings		3,952			7,571
Other liabilities		2,539			2,995
Total liabilities		685,456			687,472

Stockholders’ equity
Preferred stock, no par value; 10,000,000 shares authorized;
16,369 shares issued and outstanding		15,887			15,786
Common stock, $5.00 par value; 35,000,000 shares authorized;
5,168,546 and 5,097,058 shares issued and outstanding at
June 30, 2011 and December 31, 2010, respectively		25,843			25,485
Common stock warrant		1,016			1,016
Additional paid-in capital		17,148			17,533
Retained deficit		(21,570	)		(21,563	)
Accumulated other comprehensive gain (loss)		138			(925	)
Total stockholders’ equity		38,462			37,332
Total liabilities and stockholders’ equity	$	723,918		$	724,804

See accompanying notes to consolidated financial statements

1st Financial Services Corporation
Consolidated Statements of Operations
Three and Six Months Ended June 30, 2011 and 2010 (Unaudited)

	Three Months Ended June 30					Six Months Ended June 30
(dollars in thousands, except per share data)	2011			2010		2011			2010

Interest income
Loans and fees on loans	$	6,039		$	7,013	$	12,121		$	14,188
Investment securities		1,129			615		2,142			1,158
Due from Federal Reserve Bank		21			62		42			141
Interest-earning deposits with banks		22			4		40			4
Total interest income		7,211			7,694		14,345			15,491
Interest expense
Deposits		1,891			2,536		3,921			5,160
Federal funds purchased and securities sold under
agreements to repurchase		1			1		3			3
Other borrowings		6			93		17			272
Total interest expense		1,898			2,630		3,941			5,435
Net interest income		5,313			5,064		10,404			10,056
Provision for loan losses		2,120			720		2,806			1,020
Net interest income after provision for loan losses		3,193			4,344		7,598			9,036
Noninterest income
Service charges on deposit accounts		624			579		1,215			1,114
Mortgage services revenue		423			495		993			818
Other service charges and fees		152			119		299			230
Increase in cash surrender value of life insurance		112			117		219			230
Gains on sales of investment securities, net		-			377		-			500
USDA/SBA loan sale and servicing revenue		12			108		224			129
Other income		49			25		78			30
Total noninterest income		1,372			1,820		3,028			3,051
Noninterest expense
Salaries and employee benefits		2,106			2,675		4,458			5,131
Occupancy		219			423		587			839
Equipment		240			315		485			639
Advertising		76			124		128			272
Data processing and telecommunications		525			504		1,036			985
Deposit insurance premiums		408			420		958			1,080
Professional fees		74			326		231			561
Printing and supplies		37			66		81			134
Dues and subscriptions		47			47		96			93
Postage		44			22		82			54
Foreclosed real estate		411			167		772			361
Loss on sale of repossessed assets		2			9		2			9
Debt extinguishment expense		-			66		-			66
Loan legal		115			122		245			151
Loan appraisal		58			9		144			43
Other loan related expense		972			6		983			12
Corporate insurance		56			28		107			46
Other		211			302		424			579
Total noninterest expense		5,601			5,631		10,819			11,055
Income (loss) before income taxes		(1,036	)		533		(193	)		1,032
Income tax expense (benefit)		(528	)		168		(287	)		319
Net income (loss)		(508	)		365		94			713
Accretion of preferred stock to redemption value		51			51		101			101
Dividends on preferred stock		205			205		409			409
Net income (loss) available to common stockholders	$	(764	)	$	109	$	(416	)	$	203


Basic net income (loss) per share	$	(0.15	)	$	0.02	$	(0.08	)	$	0.04
Diluted net income (loss) per share	$	(0.15	)	$	0.02	$	(0.08	)	$	0.04
Basic weighted average shares outstanding		5,143,360			5,024,482		5,115,364			5,021,167
Diluted weighted average shares outstanding		5,143,360			5,024,482		5,115,364			5,022,939

See accompanying notes to consolidated financial statements

1st Financial Services Corporation

Consolidated Statements of Changes in Stockholders’ Equity

Six Months Ended June 30, 2011 and 2010

	Common Stock								Preferred Stock				Additional Paid-in			Retained			Accumulated Other Comprehensive Income
(dollars in thousands, except share data)	Shares			Amount			Warrant		Shares		Amount		Capital			Deficit			(Loss)			Total

Balance, December 31, 2009		5,010,117		$	25,050		$	1,016		16,369	$	15,583	$	17,804		$	(15,648	)	$	(43	)	$	43,762
Issuance of common stock pursuant to employee stock purchase plan		12,834			64			-		-		-		(38	)		-			-			26
Issuance of common stock pursuant to restricted stock plan		60,165			301			-		-		-		(290	)		-			-			11
Compensation expense related to stock option plan		-			-			-		-		-		23			-			-			23
Compensation expense related to restricted stock plan		-			-			-		-		-		44			-			-			44
Preferred dividend		-			-			-		-		-		-			(409	)		-			(409	)
Accretion of preferred stock to redemption value		-			-			-		-		101		-			(101	)		-			-
Comprehensive income
Net income		-			-			-		-		-		-			713			-			713
Net unrealized gain on investment securities
available for sale, net of income taxes of $291		-			-			-		-		-		-			-			464			464
Reclassification adjustment for gains																				-
included in net income, net of income taxes of $(193)		-			-			-		-		-		-			-			(307	)		(307	)
Total comprehensive income		-			-			-		-		-		-			-			-			870
Balance, June 30, 2010		5,083,116		$	25,415		$	1,016		16,369	$	15,684	$	17,543		$	(15,445	)	$	114		$	44,327


Balance, December 31, 2010		5,097,058		$	25,485		$	1,016		16,369	$	15,786	$	17,533		$	(21,563	)	$	(925	)	$	37,332
Issuance of common stock pursuant to restricted stock plan		86,488			433			-		-		-		(433	)		-			-			-
Common stock cancelled pursuant to restricted stock plan		(15,000	)		(75	)		-		-		-		63			-			-			(12	)
Forfeiture of nonvested stock options		-			-			-		-		-		(40	)		-			-			(40	)
Compensation expense related to restricted stock plan		-			-			-		-		-		24			-			-			24
Compensation expense related to stock option plan		-			-			-		-		-		1			-			-			1
Accretion of preferred stock to redemption value		-			-			-		-		101		-			(101	)		-			-
Comprehensive income
Net income		-			-			-		-		-		-			94			-			94
Net unrealized gain on investment securities
available for sale, net of income taxes of $667		-			-			-		-		-		-			-			1,063			1,063
Total comprehensive income		-			-			-		-		-		-			-			-			1,157
Balance, June 30, 2011		5,168,546		$	25,843		$	1,016		16,369	$	15,887	$	17,148		$	(21,570	)	$	138		$	38,462

See accompanying notes to consolidated financial statements

1st Financial Services Corporation
Consolidated Statements of Cash Flows
Six Months Ended June 30, 2011 and 2010 (Unaudited)

	Six Months Ended June 30
(dollars in thousands)	2011			2010

Cash flows from operating activities
Net income	$	94		$	713
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		537			612
Provision for loan losses		2,806			1,020
Deferred income taxes		182			1,635
Amortization of premium on securities, net of discount accretion		267			735
Origination of held-for-sale loans		(40,053	)		(34,743	)
Proceeds from sales of held-for-sale loans		48,249			37,522
Net gains on sales of investment securities		-			(500	)
Net gains on sales of USDA and SBA loans		(201	)		(129	)
Net gains on sales of held-for-sale loans		(916	)		(912	)
Net (gain) loss on sale of foreclosed real estate		321			(9	)
Net loss on sale of repossessed assets		2			9
Net loss on sale or disposal of equipment		2			59
Stock compensation expense (benefit)		(16	)		23
Writedown of foreclosed real estate		520			141
Increase in cash surrender value of bank-owned life insurance		(219	)		(230	)
Changes in assets and liabilities:
Accrued interest receivable		(81	)		(22	)
Other assets		1,904			(191	)
Accrued interest payable		(667	)		702
Other liabilities		(456	)		(307	)
Net cash provided by operating activities		12,275			6,128
Cash flows from investing activities
Purchases of investment securities available for sale		(50,764	)		(95,828	)
Sales of investment securities available for sale		-			34,330
Maturities of investment securities available for sale		5,177			7,885
Calls of investment securities available for sale		19,751			-
Purchases of investment securities held to maturity		-			(4,232	)
Maturities of investment securities held to maturity		50			50
Redemptions of restricted equity securities		921			-
Proceeds from sale of branch		-			4,512
Proceeds from sale of other real estate		1,230			1,645
Improvements to foreclosed assets		-			(219	)
Net decrease in loans		14,506			20,233
Purchases of property and equipment		(9	)		(72	)
Net cash used in investing activities		(9,138	)		(31,696	)
Cash flows from financing activities
Proceeds from the issuance of common stock		-			81
Net increase in deposits		2,618			11,544
Net increase (decrease) in securities sold under agreements
to repurchase and federal funds purchased		108			(439	)
Net decrease in other borrowings		(3,619	)		(17,225	)
Dividends paid on preferred stock		-			(409	)
Net cash used in financing activities		(893	)		(6,448	)
Net increase (decrease) in cash and cash equivalents		2,244			(32,016	)
Cash and cash equivalents, beginning of year		57,398			121,830
Cash and cash equivalents, end of year	$	59,642		$	89,814

Supplemental disclosure of cash flow information
Transfer of loans to foreclosed real estate	$	3,012		$	7,707
Transfer of loans to repossessed assets		-			72
Transfer of loans to held-to-maturity securities		1,250			-
Sales of nonaccrual loans		1,230			-

See accompanying notes to consolidated financial statements

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 1 - Organization and Summary of Significant Accounting Policies

Organization

1st Financial Services Corporation (“1st Financial” or the “Company”), a bank holding company registered under the Bank Holding Company Act of 1956, as amended, is the parent company for Mountain 1st Bank & Trust Company (the “Bank”). The Company essentially has no other assets or liabilities other than its investment in the Bank. Clear Focus Holdings LLC., is a wholly owned real estate holdings subsidiary of the Bank. The Company is also regulated, supervised, and examined by the Board of Governors of the Federal Reserve System. The Company’s business activity consists of directing the activities of the Bank. Accordingly, the information set forth in this report, including financial statements and related data, relates primarily to the Bank.

The Bank is a federally insured non-member commercial bank, incorporated under the laws of North Carolina on April 30, 2004. The Bank commenced operations on May 14, 2004. The Bank provides financial services through its branch network located in Western North Carolina and operates under the banking laws of North Carolina and the Rules and Regulations of the Federal Deposit Insurance Corporation (FDIC). The Bank competes with other financial institutions and numerous other non-financial services commercial entities offering financial services products. The Bank is further subject to the regulations of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities. The Bank’s customers are principally located in Western North Carolina.

Business Segments

The Company reports its activities as a single business segment. In determining proper segment definition, the Company considers the materiality of a potential segment and components of the business about which financial information is available and regularly evaluated, relative to resource allocation and performance assessment.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company, the Bank, and the Bank’s wholly owned subsidiary, Clear Focus Holdings, LLC. All intercompany transactions and balances have been eliminated in consolidation.

Basis of Presentation

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore do not include all disclosures required by generally accepted accounting principles for a complete presentation of financial statements. In the opinion of management, the consolidated financial statements contain all adjustments necessary to present fairly the financial condition of the Company as of June 30, 2011, its results of operations for the three- and six-month periods ended June 30, 2011 and 2010 and its cash flows and changes in stockholders’ equity for the six-month periods ended June 30, 2011 and 2010.

Management believes all interim period adjustments are of a normal recurring nature. These consolidated financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2010, contained in the Company’s filing on Form 10-K with the Securities and Exchange Commission. The accounting policies of the Company and the Bank follow generally accepted accounting principles and practices within the financial services industry.

Estimates

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities as of the date of the balance sheets and the reported amounts of income and expense for the periods presented. Actual results could differ significantly from those estimates.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Material estimates that are particularly susceptible to significant change in the near-term relate to the determination of the allowance for loan losses, the valuation of foreclosed real estate, the realization of the deferred tax asset, and the determination of the fair value of financial instruments.

Reclassifications

Certain amounts in the 2010 consolidated financial statements were reclassified to conform to the 2011 presentation. These reclassifications had no effect on shareholders’ equity or results of operations as previously presented.

Risk and Uncertainties

In the normal course of business, the Company encounters two significant types of overall risk: economic and regulatory. There are three main components of economic risk: credit risk, market risk, and concentration of credit risk. Credit risk is the risk of default on the Company’s loan portfolios that results from borrowers’ inability or unwillingness to make contractually required payments, or default on repayment of investment securities. Market risk includes primarily interest rate risk. The Company is exposed to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or different bases, than its interest-earning assets. Market risk also reflects the risk of declines in the valuation of loans held for sale and in the value of the collateral underlying loans and the value of real estate held by the Company. Concentration of credit risk refers to the risk that, if the Company extends a significant portion of its total outstanding credit to borrowers in a specific geographical area or industry or on the security of a specific form of collateral, the Company may experience disproportionately high levels of default and losses if those borrowers, or the value of such type of collateral, is adversely impacted by economic or other factors that are particularly applicable to such borrowers or collateral. Concentration of credit risk is also similarly applicable to the investment securities portfolio.

The Company and the Bank are subject to the regulations of various government agencies. These regulations can and do change significantly from period to period. The Company and the Bank also undergo periodic examinations by regulatory agencies, which may subject them to changes with respect to asset valuations, amount of required allowance for loan loss, or operating restrictions.

Subsequent Events

We have evaluated events and transactions through our filing date for potential recognition or disclosure in the consolidated financial statements.

Recent Accounting Developments

The following is a summary of recent authoritative pronouncements that could impact the accounting, reporting and/or disclosure of financial information by the Company.

In July 2010, the Receivables topic of the Accounting Standards Codification (“ASC”) was amended by Accounting Standards Update (“ASU”) 2010-20 to require expanded disclosures related to a company’s allowance for credit losses and the credit quality of its financing receivables. The amendments require the allowance disclosures to be provided on a disaggregated basis. See Note 5 to the consolidated financial statements for the required disclosures.

Disclosures about Troubled Debt Restructurings (“TDRs”) required by ASU 2010-20 were deferred by the Financial Accounting Standards Board (“FASB”) in ASU 2011-01 issued in January 2011. In April 2011, the FASB issued ASU 2011-02 to assist creditors with their determination of when a restructuring is a TDR. The determination is based on whether the restructuring constitutes a concession and whether the debtor is experiencing financial difficulties as both elements must be present. Disclosures related to TDRs under ASU 2010-20 are effective for the Company beginning this reporting period, and are included in Note 5 to the consolidated financial statements.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations, or cash flows.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 2 - Enforcement Actions

Consent Order. During 2009, the FDIC conducted a periodic examination of the Bank. As a consequence of this examination, effective February 25, 2010, the Bank entered into a Stipulation to the Issuance of a Consent Order (the Stipulation) agreeing to the issuance of a Consent Order (the Consent Order) with the FDIC and the North Carolina Commissioner of Banks (the Commissioner).

Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Bank or its Board of Directors to undertake a number of actions:

●

enhance its supervision of the Bank’s activities.

●

assess the management team to ensure executive officers have the skills, training, abilities, and experience needed.

●

develop and implement a plan for achieving and maintaining Tier 1 Capital of at least 8% of total assets, a Total Risk Based Capital Ratio of at least 12%, and a fully funded allowance for loan and lease losses.

●

strengthen the Allowance policy of the Bank.

●

develop and implement a strategic plan.

●

not extend additional credit to any borrower who had a loan with the Bank that was charged off or who has a current loan that is classified “Loss” or “Doubtful”.

●

formulate a detailed plan to collect, charge off or improve the quality of each of its “Substandard” or “Doubtful” loans.

●

reduce loans in excess of $250,000 and classified as “Substandard” or “Doubtful” in accordance with a schedule required by the supervisory authorities.

●

cause full implementation of its loan underwriting, loan administration, loan documentation, and loan portfolio management policies.

●

adopt a loan review and grading system.

●

develop a plan to systematically reduce the concentration in a limited group of borrowers.

●

enhance its review of its liquidity and implement a liquidity contingency and asset/liability management plan.

●

implement a plan and 2010 budget designed to improve and sustain earnings.

●

implement internal routine and control policies addressing concerns to enhance its safe and sound operation.

●

implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.

●

implement a policy for managing its “owned real estate”.

●

forebear from soliciting and accepting “brokered deposits” without approval.

●

limit growth to 10% per year.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

●

not pay dividends without prior approval.

●

implement policies to enhance the handling of transactions with officers and directors.

●

correct any violations of laws and regulations.

●

make quarterly progress reports.

The foregoing description is a summary of the material terms of the Consent Order and is qualified in its entirety by reference to the Consent Order. The Consent Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

The plans, policies, and procedures which the Bank is required to prepare under the Consent Order are subject to approval by the supervisory authorities before implementation. During the period a consent order, having the general provisions discussed above, is in effect, the financial institution is discouraged from requesting approval to either expand through acquisitions or open additional branches. Accordingly, the Bank will defer expanding its current markets or entering into new markets through acquisition or branching until the Consent Order is terminated.

Written Agreement. As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, the Company executed a written agreement (the Written Agreement) with the Federal Reserve Bank of Richmond (FRB), effective October 13, 2010.

Although the Company neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Written Agreement, which requires it to undertake a number of actions, including, among other things that the Company or its Board of Directors shall:

●

take appropriate steps to fully utilize the Company’s financial and managerial resources, to serve as a source of strength to the Bank.

●

not declare or pay any dividends without approval.

●

not directly or indirectly take dividends from the Bank without approval.

	●		not directly or indirectly, incur, increase, or guarantee any debt without approval. not directly or indirectly, purchase or redeem any shares of its stock without approval.

	●		comply with the notice provisions of the Federal Deposit Insurance Act and Regulation Y of the Board of Governors of the Federal Reserve System related to changes in executive officers and compensation matters.

●

submit a written capital plan that is acceptable to the Federal Reserve Bank, implement the approved plan, and thereafter fully comply with it.

The Company and the Bank have taken and continue to take prompt and aggressive actions to respond to the issues raised in the Consent Order and the Written Agreement, as discussed in Item 7 of the 2010 Annual Report on Form 10-K under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

Note 3 - Restrictions on Cash

The Company is required to maintain average reserve balances, computed by applying prescribed percentages to its various types of deposits, either at the Company or on deposit with the Federal Reserve Bank. At June 30, 2011 and December 31, 2010, all required reserves were met by the Company’s vault cash.

At June 30, 2011 and December 31, 2010, cash and cash equivalents totaling $6.9 million and $890,000, respectively, were pledged as collateral against the Bank’s check clearing and debit card activity.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 4 - Investment Securities

The Company maintains a portfolio of investment securities as part of its asset/liability and liquidity management program, which emphasizes effective yields and maturities to match its funding needs. The composition of the investment portfolio is examined periodically and appropriate realignments are initiated to meet liquidity and interest-rate sensitivity needs for the Company.

Unrealized gains and losses on available-for-sale securities are reported net of tax as a separate component of stockholders’ equity. Realized gains and losses on the sale of available-for-sale securities are determined using the specific-identification method. Premiums and discounts are recognized in interest income using the effective interest rate method over the period to maturity or call date.

Available-for-sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held-to-maturity securities. Investments in available-for-sale securities are as follows:

Available-for-Sale Securities

(in thousands)

	June 30, 2011
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
U.S. government agencies	$	7,124	$	109	$	94	$	7,139
Government-sponsored enterprises		41,928		73		691		41,310
Mortgage-backed securities		108,427		1,283		455		109,255
Total	$	157,479	$	1,465	$	1,240	$	157,704


	December 31, 2010
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
U.S. government agencies	$	5,392	$	2	$	71	$	5,323
Government-sponsored enterprises		45,026		62		1,049		44,039
Mortgage-backed securities		81,501		387		836		81,052
Total	$	131,919	$	451	$	1,956	$	130,414

During the first six months of 2011, U.S. government-sponsored securities totaling $19.8 million were called. There were no sales of investment securities during the first six months of 2011. During the first six months of 2010, proceeds from the sales of investment securities available for sale totaled $34.3 million. Gross realized gains and losses from these sales totaled $502,000 and $2,000, respectively.

Investment securities with an amortized cost of $26.7 million and a fair value of $26.3 million were pledged as collateral for securities sold under agreements to repurchase and other banking purposes at June 30, 2011.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Held-to-maturity securities are bonds, notes and debentures, for which the Company has the positive intent and ability to hold to maturity and are reported at cost, adjusted by premiums and discounts that are recognized in interest income using the effective interest rate method over the period to maturity or call date. Investments in held-to-maturity securities are as follows:

Held-to-Maturity Securities

(in thousands)

	June 30, 2011
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
States and political subdivisions	$	2,714	$	80	$	-	$	2,794
Other debt securities		1,250		-		-		1,250
Total	$	3,964	$	80	$	-	$	4,044

		December 31, 2010
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
States and political subdivisions	$	2,765	$	43	$	66	$	2,742
Total	$	2,765	$	43	$	66	$	2,742

Declines in the fair value of individual held-to-maturity and available-for-sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses. During the six months ended June 30, 2011 and 2010, the Company experienced no declines in the value of securities that were considered to be other than temporary in nature.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

The following table details the gross unrealized losses and related fair values in the Company’s available-for-sale investment securities portfolio. This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position.

Available-for-Sale Securities - Temporarily Impaired
(in thousands)
	June 30, 2011
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses


U. S. government agencies	$	1,901	$	7	$	2,374	$	87	$	4,275	$	94
Government sponsored enterprises		29,572		691		-		-		29,572		691
Mortgage-backed securities		33,841		455		-		-		33,841		455
Total	$	65,314	$	1,153	$	2,374	$	87	$	67,688	$	1,240

	December 31, 2010
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses


U. S. government agencies	$	-	$	-	$	4,557	$	71	$	4,557	$	71
Government sponsored enterprises		28,218		1,049		-		-		28,218		1,049
Mortgage-backed securities		41,528		836		-		-		41,528		836
Total	$	69,746	$	1,885	$	4,557	$	71	$	74,303	$	1,956

A total of three individual U.S. government agency securities (two U.S. Department of Agriculture securities and one Small Business Administration security) were in a continuous loss position for 12 months or more at June 30, 2011 in comparison to a total of seven individual available-for-sale securities that were in a continuous loss position for 12 months or more at December 31, 2010. The Company has the ability and intent to hold these securities until such time as the value recovers or the security matures. The Company believes, based on their credit ratings, that the deterioration in value is attributable to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered to be other than temporary.

The following table details the gross unrealized losses and related fair values in the Company’s held-to-maturity investment securities portfolio. This information is aggregated by the length of time that individual securities have been in a continuous unrealized loss position as of December 31, 2010. No held-to-maturity securities were in an unrealized loss position at June 30, 2011.

Held-to-Maturity Securities - Temporarily Impaired
(in thousands)
	December 31, 2010
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses

States and political subdivisions	$	1,946	$	66	$	-	$	-	$	1,946	$	66
Total	$	1,946	$	66	$	-	$	-	$	1,946	$	66

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

The aggregate amortized cost and fair value of available-for-sale and held-to-maturity investment securities by remaining contractual maturity are shown below. Actual expected maturities differ from contractual maturities because issuers may have the right to call or prepay obligations.

Available-for-Sale Investment Securities
(in thousands)
	June 30, 2011				December 31, 2010
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
U. S. government agencies
Due within one year	$	98	$	99	$	-	$	-
Due after one but within five years		307		309		555		555
Due after five but within ten years		1,085		1,087		1,160		1,157
Due after ten years		5,634		5,644		3,677		3,611
Government-sponsored enterprises
Due within one year		-		-		-		-
Due after one but within five years		-		-		3,998		4,008
Due after five but within ten years		25,938		25,573		28,038		27,576
Due after ten years		15,990		15,737		12,990		12,455
Mortgage-backed securities		108,427		109,255		81,501		81,052
Total	$	157,479	$	157,704	$	131,919	$	130,414


Held-to-Maturity Investment Securities
(in thousands)
	June 30, 2011				December 31, 2010
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
States and political subdivisions
Due within one year	$	101	$	102	$	50	$	50
Due after one but within five years		401		433		403		422
Due after five but within ten years		200		224		300		324
Due after ten years		2,012		2,035		2,012		1,946
Other debt securities
Due within one year		-		-		-		-
Due after one but within five years		-		-		-		-
Due after five but within ten years		1,250		1,250		-		-
Due after ten years		-		-		-		-
Total	$	3,964	$	4,044	$	2,765	$	2,742

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 5 - Loans

Following is a summary of the major components of loans, excluding loans held for sale.

Loans
(in thousands)
	June 30,			December 31,
	2011			2010
Real estate:
Construction and development	$	105,561		$	114,532
1-4 family residential		115,914			120,217
Mutlifamily		5,805			6,417
Farmland		952			965
Nonfarm, nonresidential		170,237			173,326
Total real estate		398,469			415,457
Commercial and industrial loans		58,269			66,254
Consumer		3,705			4,484
		460,443			486,195
Allowance for loan losses		(11,812	)		(16,191	)
Total	$	448,631		$	470,004

At June 30, 2011, the Company had $38.7 million in non-accruing loans, compared to $37.8 million at December 31, 2010. The year-to-date foregone interest associated with these loans, which averaged $41.5 million for the first six months of 2011 and $30.9 million for the similar period in 2010, was $1.2 million and $931,000 for the respective periods.

Credit Quality Indicators. As part of the on-going monitoring of the credit quality of the Company’s loan portfolio, management tracks certain credit quality indicators including trends related to (i) the weighted-average risk grade of commercial loans, (ii) the level of classified commercial loans, (iii) net charge-offs, (iv) non-performing loans and (v) the general economic conditions in the State of North Carolina.

The Company uses a risk grading matrix to assign a risk grade to each of its commercial loans. Loans are graded on a scale of 1 to 9. A description of the general characteristics of the nine risk grades is as follows:

●

Rating 1 –Extremely Low Risk. Low Risk Assets are of the highest quality with an unquestioned capacity for repayment. These borrowers are generally international, national, or regional in scope and the debt rating, if available, is AAA (S&P) or Aaa (Moody’s). The borrower has ready access to all public financing markets. Management has a demonstrated successful track record and a succession plan is in place for highly qualified replacements. Financial statements are audited without qualification by reputable CPA firms. Loans are also considered extremely low risk prime when the collateral consists of properly margined Bank CDs and shorter-term U.S. government securities.

●

Rating 2 -Minimal Risk. Minimal Risk Assets have a history of consistently superior earnings and cash flow. Very strong liquidity and low leverage. The balance sheet is well capitalized and the secondary source of repayment is well defined and of unquestioned quality. These borrowers also have ready access to all public finance markets as evidenced by debt ratings, if available, of AA (S&P) or Aaa (Moody’s). These assets can also be those secured by properly margined long term U.S. government bonds.

●

Rating 3 –Moderate Risk. Moderate Risk assets have consistently satisfactory earnings and cash flow. They possess no disclosed weaknesses; however, financial analysis reveals factors such as leverage, liquidity, or debt service to be less than optimal or susceptible to changes in the business cycle. Access to other financing sources exists and private placement may be possible. Unqualified audited statements are preferred; however reviewed statements are also acceptable. The borrower may not be able to survive a significant downturn; however, the debt is supported by high quality unrestricted liquid collateral.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

●

Rating 4 –Satisfactory Risk. Satisfactory Risk assets possess adequate earnings, cash flow, leverage, and capital when compared to their industry. Debt service does not place an undue strain on the business. The borrower is not strong enough to sustain major financial setbacks. The asset has a readily apparent weakness such as being relatively new, new management with an unproven track record, low liquidity or equity, volatile profitability and cash flow. Guarantor(s) and collateral that provide an acceptable and readily quantifiable secondary source of repayment always support these assets.

●

Rating 5 –Acceptable Risk – “Management Watch.” Acceptable Risk Assets are those that warrant closer than normal attention due to adverse conditions affecting the borrower, the borrowers industry, or the general economic environment. Above average risk is reflected through erratic earnings and cash flow, inconsistent debt service coverage, or strained liquidity or leverage. Uncertain events may have taken place such as unanticipated management changes or pending litigation that could have a significant negative impact. Collateral and/or guarantor(s) adequately protect these assets.

●

Rating 6 –Special Mention. A Special Mention asset has potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or in the institution’s credit position at some future date. Special Mention assets are not adversely classified and do not expose the Bank to sufficient risk to warrant adverse classification.

●

Rating 7 –Substandard . Loans with a well-defined weakness, some loss may be possible, though not anticipated. A substandard asset is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility the Bank will sustain some loss if the deficiencies are not corrected. Loss potential, while existing in the aggregate amount of substandard assets, does not have to exist in individual assets classified substandard.

●

Rating 8 –Doubtful. Doubtful asset has all the weaknesses inherent in an asset classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable and improbable. The possibility of loss is extremely high, but because of certain important and reasonable specific pending factors that may work to the advantage and strengthening of the asset, its classification as an estimated loss is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral and refinancing plans. A substandard credit with 50 percent or more liquidated collateral value shortfall would generally be considered doubtful, unless other substantive credit factors justified otherwise.

●

Rating 9 –Loss. Assets classified as loss are considered uncollectible and of such little value that their continuance as bankable assets is not warranted. This classification does not mean the asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may be affected in the future. Losses are taken in the period in which they determined to be uncollectible.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Commercial loans with a risk rating of 1 through 5 are classified as “Pass” rated credits in the following tables. Nonrated consumer loans are also classified as “Pass.” The following is a summary of information pertaining to credit quality.

Loan Analysis by Credit Quality Indicators
(in thousands)
	June 30, 2011
	Pass		Special Mention		Substandard		Doubtful		Loss		Total

Construction and development	$	62,129	$	13,090	$	27,014	$	3,328	$	-	$	105,561
1-4 family residential		100,172		1,495		12,088		2,159		-		115,914
Multifamily		5,805		-		-		-		-		5,805
Farmland		952		-		-		-		-		952
Nonfarm, non residential		133,038		14,734		22,253		212		-		170,237
Total real estate loans		302,096		29,319		61,355		5,699		-		398,469
Commercial and industrial		44,890		5,681		4,588		3,110		-		58,269
Consumer		3,704		1		-		-		-		3,705
Total loans	$	350,690	$	35,001	$	65,943	$	8,809	$	-	$	460,443



	December 31, 2010
	Pass		Special Mention		Substandard		Doubtful		Loss		Total

Construction and development	$	66,075	$	9,033	$	38,115	$	1,309	$	-	$	114,532
1-4 family residential		101,321		1,491		14,517		2,888		-		120,217
Multifamily		6,417		-		-		-		-		6,417
Farmland		965		-		-		-		-		965
Nonfarm, non residential		137,252		11,888		23,457		729		-		173,326
Total real estate loans		312,030		22,412		76,089		4,926		-		415,457
Commercial and industrial		53,243		6,215		3,178		3,618		-		66,254
Consumer		4,480		-		4		-		-		4,484
Total loans	$	369,753	$	28,627	$	79,271	$	8,544	$	-	$	486,195

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

The following is a summary loan aging analysis.

Loan Aging Analysis
(in thousands)
	June 30, 2011
									Total
	Past Due and Accruing								Past Due
	30-59 days		60-89 days		90 or more days		Nonaccrual		& Nonaccrual		Current		Total Loans

Construction and development	$	698	$	51	$	-	$	13,186	$	13,935	$	91,626	$	105,561
1-4 family residential		799		892		-		12,100		13,791		102,123		115,914
Multifamily		-		-		-		-		-		5,805		5,805
Farmland		-		-		-		-		-		952		952
Nonfarm, non residential		3,934		-		-		6,601		10,535		159,702		170,237
Total real estate loans		5,431		943		-		31,887		38,261		360,208		398,469
Commercial and industrial		91		-		-		6,830		6,921		51,348		58,269
Consumer		-		-		-		12		12		3,693		3,705
Total loans	$	5,522	$	943	$	-	$	38,729	$	45,194	$	415,249	$	460,443



	December 31, 2010
									Total
	Past Due and Accruing								Past Due
	30-59 days		60-89 days		90 or more days		Nonaccrual		& Nonaccrual		Current		Total Loans

Construction and development	$	186	$	-	$	-	$	12,487	$	12,673	$	101,859	$	114,532
1-4 family residential		2,021		608		5		11,042		13,676		106,541		120,217
Multifamily		-		-		-		-		-		6,417		6,417
Farmland		-		-		-		-		-		965		965
Nonfarm, non residential		1,467		532		-		8,285		10,284		163,042		173,326
Total real estate loans		3,674		1,140		5		31,814		36,633		378,824		415,457
Commercial and industrial		640		1,747		-		5,966		8,353		57,901		66,254
Consumer		31		15		-		19		65		4,419		4,484
Total loans	$	4,345	$	2,902	$	5	$	37,799	$	45,051	$	441,144	$	486,195

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

The following tables outline the changes in the allowance for loan losses by collateral type, the allowances for loans individually and collectively evaluated for impairment, and the amount of loans individually and collectively evaluated for impairment at June 30, 2011 and December 31, 2010.

Allowance for Loan Losses and Recorded Investment in Loans Receivable
(in thousands)
	As of and for the Six Months Ended June 30, 2011
	Construction & Land Development			1-4 Family Residential			Multifamily			Farmland		Nonfarm, Nonresidential			Commercial & Industrial			Consumer			Unallocated			Total

Allowance for Loan Losses
Beginning balance	$	8,499		$	4,371		$	35		$	12	$	1,798		$	1,412		$	64		$	-		$	16,191
Provision for loan losses		(316	)		760			(2	)		1		354			1,977			32			-			2,806
Charge-offs		(3,055	)		(1,555	)		-			-		(1,180	)		(1,423	)		(41	)		-			(7,254	)
Recoveries		3			5			-			-		-			53			8			-			69
Ending balance	$	5,131		$	3,581		$	33		$	13	$	972		$	2,019		$	63		$	-		$	11,812

Ending allowance balance for loans individually evaluated for impairment	$	3,123		$	2,725		$	-		$	-	$	310		$	1,138		$	-		$	-		$	7,296

Ending allowance balance for loans collectively evaluated for impairment	$	2,008		$	855		$	33		$	13	$	662		$	882		$	63		$	-		$	4,516

Loans Receivable
Total period-end balance	$	105,561		$	115,914		$	5,805		$	952	$	170,237		$	58,269		$	3,705		$	-		$	460,443
Balance of loans individually evaluated for impairment	$	30,367		$	14,960		$	-		$	-	$	22,455		$	7,213		$	-		$	-		$	74,995
Balance of loans collectively evaluated for impairment	$	75,194		$	100,954		$	5,805		$	952	$	147,782		$	51,056		$	3,705		$	-		$	385,448


	As of and for the Year Ended December 31, 2010
	Construction & Land Development			1-4 Family Residential			Multifamily			Farmland		Nonfarm, Nonresidential			Commercial & Industrial			Consumer			Unallocated			Total

Allowance for Loan Losses
Beginning balance	$	15,454		$	5,010		$	27		$	-	$	3,232		$	3,964		$	183		$	361		$	28,231
Provision for loan losses		8,642			2,370			192			12		(626	)		1,905			328			(361	)		12,462
Charge-offs		(16,008	)		(3,043	)		(184	)		-		(812	)		(4,706	)		(475	)		-			(25,228	)
Recoveries		411			34			-			-		4			249			28			-			726
Ending balance	$	8,499		$	4,371		$	35		$	12	$	1,798		$	1,412		$	64		$	-		$	16,191

Ending allowance balance for loans individually evaluated for impairment	$	6,849		$	3,496		$	-		$	-	$	1,206		$	596		$	-		$	-		$	12,147
Ending allowance balance for loans collectively evaluated for impairment	$	1,650		$	875		$	35		$	12	$	592		$	816		$	64		$	-		$	4,044

Loans Receivable
Total period-end balance	$	114,532		$	120,217		$	6,417		$	965	$	173,326		$	66,254		$	4,484		$	-		$	486,195
Balance of loans individually evaluated for impairment	$	39,844		$	18,383		$	-		$	-	$	23,989		$	6,493		$	4		$	-		$	88,713
Balance of loans collectively evaluated for impairment	$	74,688		$	101,834		$	6,417		$	965	$	149,337		$	59,761		$	4,480		$	-		$	397,482

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

The following table summarizes information relative to impaired loans.

Impaired Loan Schedule
(in thousands)
	June 30, 2011
	Construction and		1-4 Family		Nonfarm		Commercial
	Development		Residential		Non residential		and Industrial		Consumer		Total

With no related allowance recorded
Recorded investment	$	17,746	$	4,320	$	19,315	$	2,513	$	-	$	43,894
Unpaid principal balance		19,623		4,382		19,975		2,577		-		46,557
Related allowance		-		-		-		-		-		-
Average recorded investment		18,257		4,718		19,319		2,525		-		44,819
Interest income recognized		388		90		418		1		-		897
With an allowance recorded
Recorded investment	$	12,621	$	10,640	$	3,140	$	4,700	$	-	$	31,101
Unpaid principal balance		12,959		12,395		3,272		6,789		-		35,415
Related allowance		3,123		2,725		310		1,138		-		7,296
Average recorded investment		13,217		11,378		3,134		5,212		-		32,941
Interest income recognized		146		157		82		24		-		409
Total
Recorded investment	$	30,367	$	14,960	$	22,455	$	7,213	$	-	$	74,995
Unpaid principal balance		32,582		16,777		23,247		9,366		-		81,972
Related allowance		3,123		2,725		310		1,138		-		7,296
Average recorded investment		31,474		16,096		22,453		7,737		-		77,760
Interest income recognized		534		247		500		25		-		1,306

	December 31, 2010
	Construction and		1-4 Family		Nonfarm		Commercial
	Development		Residential		Non residential		and Industrial		Consumer		Total

With no related allowance recorded
Recorded investment	$	16,972	$	5,455	$	17,047	$	4,896	$	4	$	44,374
Unpaid principal balance		17,149		5,481		17,349		7,733		4		47,716
Related allowance		-		-		-		-		-		-
Average recorded investment		17,502		5,441		17,215		6,491		5		46,654
Interest income recognized		974		266		892		166		1		2,299
With an allowance recorded
Recorded investment	$	22,872	$	12,928	$	6,942	$	1,597	$	-	$	44,339
Unpaid principal balance		24,172		14,905		7,097		1,627		-		47,801
Related allowance		6,849		3,496		1,206		596		-		12,147
Average recorded investment		21,533		13,925		6,956		1,814		-		44,228
Interest income recognized		886		395		316		66		-		1,663
Total
Recorded investment	$	39,844	$	18,383	$	23,989	$	6,493	$	4	$	88,713
Unpaid principal balance		41,321		20,386		24,446		9,360		4		95,517
Related allowance		6,849		3,496		1,206		596		-		12,147
Average recorded investment		39,035		19,366		24,171		8,305		5		90,882
Interest income recognized		1,860		661		1,208		232		1		3,962

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

The following tables summarize information relative to loan modifications determined to be troubled debt restructurings. As of June 30, 2011, all the troubled debt restructurings are included in impaired loans.

Troubled Debt Restructurings
(in thousands, except contracts)
	June 30, 2011
	Number of Contracts		Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment

Construction & land development		2	$	1,589	$	1,289
1-4 family residential		5		2,229		2,175
Nonfarm, nonresidential		5		8,209		5,547
Total real estate loans		12		12,027		9,011
Commercial and industrial		2		28		20
Total loans		14	$	12,055	$	9,031

Troubled Debt Restructurings that Subsequently Defaulted
(in thousands, except contracts)
			June 30, 2011
			Number of Contracts		Recorded Investment

Construction & land development				1	$	4
1-4 family residential				2		288
Nonfarm, nonresidential				2		709
Total loans				5	$	1,001

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

The following table provides information about the Bank’s nonperforming assets as of June 30, 2011 and December 31, 2010.

Nonperforming Assets
(dollars in thousands)
	June 30,			December 31,
	2011			2010

Nonaccrual loans	$	38,729		$	37,799
Loan past due 90 or more days and still accruing interest		-			5
Total nonperforming loans		38,729			37,804
Foreclosed real estate		8,255			7,314
Repossessed assets		-			7
Investment in real estate partnership		6,356			-
Total nonperforming assets	$	53,340		$	45,125

Allowance for loan losses	$	11,812		$	16,191

Nonperforming loans to period-end loans,
excluding loans held for sale		8.41	%		7.78	%

Allowance for loan losses to period-end loans,
excluding loans held for sale		2.57	%		3.33	%

Nonperforming assets as a percentage of:
Loans, foreclosed real estate, and investment in real estate partnership		11.23	%		9.14	%
Total assets		7.37	%		6.23	%

Ratio of allowance for loan losses to nonperforming loans		30.5	%		42.8	%

Note 6 - Foreclosed Real Estate

The following table summarizes the activity in foreclosed real estate for the six months ended June 30, 2011.

(in thousands)

Balance at beginning of year	$	7,314
Additions		3,012
Sales		(1,551	)
Write-downs		(520	)
Balance at end of period	$	8,255

Note 7 - Restricted Equity Securities

The Bank, as a member institution is required to own stock in the Federal Home Loan Bank of Atlanta (FHLB). No ready market exists for this stock and it has no quoted market value; however, redemption of this stock has historically been at par. At June 30, 2011 and December 31, 2010, the Bank owned $3,030,800 and $3,951,500 in FHLB stock, respectively. Also included in restricted equity securities at June 30, 2011 and December 31, 2010 was an investment in Capital South Partners, LLC (a Small Business Investment Corporation) of $962,500, an investment in the Senior Housing Crime Prevention Fund of $500,000, and an investment in Pacific Coast Bankers Bank stock of $102,000.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 8 - Investment in Real Estate Partnership

During 2009, the Bank became a member in a limited liability corporation (LLC). The Bank contributed two nonperforming loans with an aggregate principal amount outstanding of $6.7 million to the LLC, while the other members contributed professional real estate development experience and cash sufficient to carry the properties’ operating costs for an extended period of time. The LLC is designed to hold the real estate until such time as market values return to normalized levels at which point it is anticipated that the properties will be marketed by seasoned real estate developers with the proceeds of the sale being distributed based on contractual formulas to members of the LLC. During 2010, the Bank received $311,000 as reduction of principal from the sale of a sub-parcel of one of the two properties. As of June 30, 2011 and December 31, 2010, the Bank’s investment in the LLC was $6.4 million.

During the second quarter of 2011, the Bank purchased the interest of the other LLC member for $850,000. This cost was included as other loan related expense in the consolidated statement of operations. In late July 2011, the LLC began foreclosure proceedings against the remaining loan in the LLC. Accordingly, the Company classified this investment as a nonperforming asset at June 30, 2011.

Note 9 - Time Deposits

Time deposits totaled $364.5 million at June 30, 2011, compared to $381.8 million at December 31, 2010. Of that total, time deposits in denominations of $100,000 or more were $166.6 million and $181.7 million at June 30, 2011 and December 31, 2010, respectively. Interest expense on deposits of $100,000 or more aggregated $1.4 million and $2.1 million for the six months ended June 30, 2011 and 2010, respectively. Time deposits maturing subsequent to June 30, 2011, are as follows:

(in thousands)
Maturing in	Amount
2011	$	168,316
2012		167,331
2013		12,142
2014		6,161
2015		4,873
2016		5,667
	$	364,490

At June 30, 2011 and December 31, 2010, the Company had $35.6 million and $42.4 million, respectively, in brokered certificates of deposit. Under the terms of the Consent Order, the Bank is prohibited from soliciting and accepting brokered certificates of deposit (including the renewal of existing brokered certificates of deposits), unless it first receives an appropriate waiver from the FDIC. Accordingly, as brokered certificates of deposit mature, the certificates are not being rolled over into another certificate.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 10 - Borrowings

Information related to the Company’s borrowings is summarized below.

(dollars in thousands)
	June 30, 2011					December 31, 2010
			Weighted					Weighted
			Average					Average
	Amount		Rate			Amount		Rate

Advances from the Federal Home Loan Bank	$	3,952		0.45	%	$	3,952		0.43	%
Securities sold under agreements to repurchase		812		0.82			704		0.88
Other secured borrowing		-		-			3,619		-
Total	$	4,764		0.51	%	$	8,275		0.43	%

Note 11 – Income Taxes

Deferred tax assets represent the future tax benefit of deductible differences and, if it is more likely than not that a tax asset will not be realized, a valuation allowance is required to reduce the recorded deferred tax assets to net realizable value. During 2009, in consideration of uncertainties regarding the timing of improvements in current economic conditions, management provided allowances of $4.0 million to reflect its estimate of net realizable value as of the financial statement date. As of June 30, 2011, management determined based on its projections of future operating results over the next several years, cumulative tax losses over the previous three years, tax loss deductibility limitations and available tax planning strategies, it was more likely than not that all assets, net of the $4.0 million allowance, would be realized. The Company’s net deferred tax asset was $9.6 million and $10.1 million at June 30, 2011 and December 31, 2010, respectively.

Pursuant to accounting pronouncement ASC 740-10, the Company has reviewed its income tax positions and specifically considered the recognition and measurement requirements of the benefits recorded in its financial statements for tax positions taken or expected to be taken in its tax returns. Based on its evaluation of these tax positions for its open tax years, the Company has not recorded any tax liability or uncertain tax positions as of June 30, 2011 and December 31, 2010. Federal tax returns have been examined by the Internal Revenue Service through 2008.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 12 - Allowance for Loan Losses

An analysis of the changes in the allowance for loan losses is as follows:

(dollars in thousands)
	Three Months Ended June 30						Six Months Ended June 30
	2011			2010			2011			2010

Balance at beginning of period	$	13,905		$	25,691		$	16,191		$	28,231
Provision for loan losses		2,120			720			2,806			1,020
Charge-offs
Construction and development		959			4,579			3,055			5,569
1-4 family residential		1,258			349			1,555			1,688
Multifamily		-			-			-			184
Nonfarm, non residential		1,148			479			1,180			695
Total real estate		3,365			5,407			5,790			8,136
Commercial		850			245			1,423			527
Consumer		24			138			41			313
Total charge-offs		4,239			5,790			7,254			8,976
Recoveries
Construction and development		3			3			3			330
1-4 family residential		2			1			5			4
Nonfarm, non residential		-			4			-			4
Total real estate		5			8			8			338
Commercial		17			1			53			14
Consumer		4			2			8			5
Total recoveries		26			11			69			357
Net charge-offs		4,213			5,779			7,185			8,619
Balance at end of period	$	11,812		$	20,632		$	11,812		$	20,632
Average loans, excluding loans held for sale	$	475,409		$	529,270		$	478,571		$	539,059
Period end loans, excluding loans held for sale	$	460,443		$	515,462		$	460,443		$	515,462
Net charge-offs to average loans,
excluding loans held for sale (1)		3.55	%		4.38	%		3.03	%		3.22	%
Allowance for loan losses to period end loans,
excluding loans held for sale		2.57	%		4.00	%		2.57	%		4.00	%

(1) Annualized

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Note 13 - Net Income (Loss) per Share

Basic income (loss) per share represents the net income allocated to common stockholders divided by the weighted-average number of common shares outstanding during the period. Dilutive income (loss) per share reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued. The number of common shares that may be issued by the Company pursuant to outstanding stock options and stock warrants are determined using the treasury stock method.

For the six months ended June 30, 2011, basic weighted average shares and diluted weighted average shares outstanding totaled 5,115,364 amounting to basic earnings (loss) per share and diluted earnings (loss) per share of ($0.08) per share for the period. For the six months ended June 30, 2010, basic weighted average shares and diluted weighted average shares outstanding totaled 5,021,167 and 5,022,939 respectively, resulting in basic earnings (loss) per share and diluted earnings (loss) per share of $0.04 per share for the period.

Additionally, 694,600 shares attributable to outstanding stock options and 276,815 warrants to purchase common stock were excluded from the calculation of net income (loss) per share for the six months ended June 30, 2011, because their inclusion was not deemed to be dilutive as their exercise price was greater than the average market price of the common shares. For the six months ended June 30, 2010, 810,847 shares and 276,815 warrants were excluded from the net income (loss) per share calculations for the same reason.

Note 14 - Contingent Liabilities, Commitments and Uncertainties

Litigation

In the normal course of business, the Company is often involved in various legal proceedings. Management believes any liability resulting from such proceedings will not be material to the consolidated financial statements.

Risks and Uncertainties

In the normal course of its business, the Company encounters numerous risks. Two of the most significant of these types of risk are economic and regulatory. There are three main components of economic risk; interest rate risk, credit risk, and market risk. The Company is subject to interest rate risk to the degree that its interest-bearing liabilities mature or reprice at different speeds, or on different bases, than its interest-earning assets. Credit risk is the risk of default on the Company’s loan portfolio that results from borrowers’ inability or unwillingness to make contractually required payments. Market risk reflects changes in the value of collateral underlying loans receivable, the valuation of real estate held by the Company, and the valuation of loans held for sale and investment securities available for sale.

The Company is subject to the regulations of various governmental agencies. These regulations can and do change significantly from period to period. The Company also undergoes periodic examinations by the regulatory agencies, which may subject it to further changes with respect to asset valuations, amounts of required loss allowances, and operation restrictions, resulting from the regulators’ judgments based on information available to them at the time of their examination. See Note 2 – Enforcements Actions for discussion of the Consent Order and the Written Agreement entered into by the Bank and the Company, respectively, during 2010.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Financial Instruments with Off-Balance-Sheet-Risk

The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. These instruments involve, to varying degrees, credit risk in excess of the amount recognized in the balance sheets. The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as for on-balance-sheet instruments. A summary of the Company’s commitments are as follows:

(in thousands)
	June 30,		December 31,
	2011		2010

Commitments to extend credit	$	46,372	$	57,061
Standby letters of credit		432		1,328
Total	$	46,804	$	58,389

Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the party. Collateral held varies, but may include accounts receivable, inventory, property and equipment, residential real estate and income-producing commercial properties.

Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. Those guarantees are primarily issued to support public and private borrowing arrangements. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held varies as specified above, and is required in instances which the Company deems necessary. Since most of the letters of credit are expected to expire without being drawn upon, they do not necessarily represent future cash requirements. The Company has not recorded a liability for the current carrying amount of the obligation to perform as a guarantor, and no contingent liability was considered necessary, as such amounts were not considered material.

Concentrations of Credit Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of loans, investment securities, federal funds sold and amounts due from banks with loans accounting for the most significant risk.

The Company makes loans to individuals and small businesses for various personal and commercial purposes primarily in Western North Carolina. Management does not consider the loan portfolio to be significantly concentrated in loans to any single borrower or a relatively small number of borrowers. Additionally, management is not aware of any concentrations of loans to classes of borrowers or industries that would be similarly affected by economic conditions.

Banking regulators have raised concern and have heightened regulatory scrutiny regarding loan portfolios with concentrations of loans collateralized by real estate, particularly commercial real estate (CRE). They have defined CRE to include construction loans, acquisition and development loans, loans collateralized with tracts of raw land for speculative purposes, any sort of commercial premise unless it is owner occupied and a number of other subcategories. Slightly more than 86.5% of the Bank’s loan portfolio is collateralized by real estate.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios (LTV). Regulatory guidelines state that the total amount of all loans in excess of the regulatory loan-to-value ratio limits should not exceed 100% of a bank’s total risk-based capital. These types of loans totaled $35.1 million at June 30, 2011, representing 92.4% of the Company’s total risk-based capital.

The Company’s investment portfolio consists principally of obligations of the United States, its agencies, government sponsored enterprises and general obligation municipal securities. In the opinion of management, there is no concentration of credit risk in the Company’s investment portfolio.

The Company places its deposits and correspondent accounts with and sells its federal funds to high quality institutions. Management believes credit risk associated with correspondent accounts is not significant.

Note 15 - Stock Based Compensation

Stock Option Plans

The Employee Stock Option Plan and the Director Stock Option Plan provide up to 497,110 shares (adjusted for all stock splits) of the Company’s common stock may be issued under each of these plans for a combined total of 994,220 shares. Options granted under the Employee Stock Option Plan and the Director Stock Option Plan may be vested immediately and expire no more than 10 years from date of grant. The exercise price for any options granted under these plans is set by the Board of Directors at the date of grant (and is adjusted on a pro rata basis for any subsequent stock split). No options were granted under either the Director Stock Option Plan or Employee Stock Option Plan during the first six months of 2011, during which period 91,443 options were forfeited. The total number of options outstanding at June 30, 2011, was 497,110 in the Director Stock Option Plan and 197,490 in the Employee Stock Option Plan.

The Company recognized $1,000 and $23,000 in stock compensation expense during the first six months of 2011 and 2010, respectively, related to the vesting of stock options. Separately, $40,000 of stock compensation expense was reversed upon the forfeiture of nonvested stock options. It is the Company’s policy to issue shares to satisfy option exercises. There were no options exercised during the first six months of 2011. As of June 30, 2011, there was no unrecognized compensation cost related to the outstanding stock options. There is no intrinsic value in these stock options as of June 30, 2011, as the exercise prices are greater than the last traded price of the Company's common stock.

A summary of the activity in the Company’s Stock Option Plans and related information for the first six months of 2011 is as follows:

	Outstanding Options					Exercisable Options
				Weighted					Weighted
				Average					Average
	Number			Exercise		Number			Exercise
	Outstanding			Price		Outstanding			Price

At January 1, 2011		786,043			$ 8.42		780,043			$ 8.41
Options granted		-			-		-			-
Options vested		-			-		-			-
Options forfeited		(91,443	)		$ 5.84		(85,443	)		5.55
At June 30, 2011		694,600			$ 8.32		694,600			$ 8.32

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Additional information concerning the Company’s Stock Option Plans as of June 30, 2011 is as follows:

						Weighted Average
					Average	Remaining
	Number		Number		Intrinsic	Contractual Life
Exercise Price	Outstanding		Exercisable		Value	(in Years)

$ 5.63		458,874		458,874	$ -		2.99
$ 13.31		217,420		217,420	$ -		4.25
$ 14.08		12,056		12,056	$ -		3.99
$ 20.60		6,250		6,250	$ -		4.42
Total		694,600		694,600	$ -		3.41

Service-Based Awards

In 2008, the Company’s stockholders approved the Omnibus Plan, pursuant to which incentive stock options, nonqualified stock options, performance shares, stock appreciation rights, and restricted stock may be granted to officers and employees of the Company and the Bank, and nonqualified stock options and restricted stock awards may be granted to directors of the Company and the Bank. An additional 250,000 shares of the Company’s common stock was reserved and made available for awards under the Omnibus Plan. The shares granted generally vest ratably over a period of three or five years.

Nonvested share activity under the Omnibus Plan for the first six months of 2011 is as follows:

				Weighted
				Average
				Grant Date
	Shares			Fair Value
Outstanding at January 1, 2011		58,165			$ 2.60
Granted		86,488			0.38
Vested		(13,722	)		2.63
Forfeited		(15,000	)		2.15
Outstanding at June 30, 2011		115,931			$ 1.00

Compensation expense recognized for nonvested service-based shares during the first six months of 2011 and 2010, totaled $24,000 and $44,000 respectively. Separately, $12,000 of stock compensation expense was reversed upon the forfeiture of nonvested service-based shares. The shares issued vest ratably over three-to-five years. As of June 30, 2011, there was $58,000 of total unrecognized compensation cost related to service-based nonvested share-based compensation arrangements granted under the Omnibus Plan. This cost is expected to be recognized over a remaining weighted-average period of 14.2 months.

Note 16 - Fair Value of Financial Instruments

Fair value estimates are made at a specific point in time based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holding of a particular financial instrument. In cases where quoted market prices are not available, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. Changes in assumptions could significantly affect the estimates. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates. Finally, the fair value estimates presented herein are based on pertinent information available to management as of June 30, 2011 and December 31, 2010.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

The following methods and assumptions were used to estimate the fair value of each class of financial instruments for which it is practicable to estimate that value:

Cash and Noninterest Bearing Bank Deposits, Federal Funds Sold, Interest Bearing Deposits with Banks, and Due from Federal Reserve Banks

The carrying amounts for cash and noninterest bearing bank deposits, federal funds sold, interest bearing deposits with banks and due from Federal Reserve banks approximate fair value because of the short maturities of those instruments. These instruments are considered cash and cash equivalents.

Investment Securities

Fair values for investment securities are based on quoted market price if such information is available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities.

Restricted Equity Securities

The carrying amount for nonmarketable equity securities approximates fair value since no readily available market exists for these securities.

Investment in Real Estate Partnership

Fair values for the investment in real estate partnership are based on estimates of future cash flows discounted to the present value.

Loans Held for Sale

Fair values of mortgage loans held for sale are based on commitments on hand from investors or prevailing market prices.

Loans

For certain homogenous categories of loans, such as residential mortgages, fair value is estimated using the quoted market prices for securities backed by similar loans, adjusted for differences in loan characteristics. The fair value of other types of loans is estimated by discounting the future cash flows using the current rate at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.

Bank Owned Life Insurance

The carrying value of life insurance approximates fair value since this investment is carried at cash surrender value, as determined by the insurer.

Deposits, Short-term Borrowings and Long-term Debt

The fair value of demand deposits and savings accounts is the amount payable on demand at the reporting date. The fair value of time deposits, short-term borrowings and long-term debt is estimated based upon the discounted value of projected future cash outflows using the rates currently offered for instruments of similar remaining maturities.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Accrued Interest Receivable and Accrued Interest Payable

The carrying amounts of accrued interest receivable and accrued interest payable are assumed to approximate fair values.

Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC Topic 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value:

Level 1	Valuation can be based on quoted prices in active markets for identical assets or liabilities.
Level 2	Valuation can be based on quoted prices for similar assets or liabilities; quoted prices in markets that are not active/or models using inputs that are observable or can be corroborated by observable market data of substantially the full term or the assets or liabilities.
Level 3	Valuation can be based on using pricing models, discounted cash flow methodologies or similar techniques and at least one significant model assumption or input is unobservable and when determination of the fair value requires significant management judgment or estimation.

The following table presents the carrying values and estimated fair values of the Company’s financial instruments.

(in thousands)
	June 30, 2011				December 31, 2010
	Carrying Value		Estimated Fair Value		Carrying Value		Estimated Fair Value
Financial assets
Cash and cash equivalents	$	59,642	$	59,642	$	57,398	$	57,398
Investment securities available for sale		157,704		157,704		130,414		130,414
Investment securities held to maturity		3,964		4,044		2,765		2,742
Restricted equity securites		4,595		4,595		5,516		5,516
Investment in real estate partnership		6,356		6,356		6,356		6,356
Loans held for sale		3,746		3,746		11,026		11,026
Loans		460,443		457,763		486,195		483,187
Bank-owned life insurance		12,736		12,736		12,517		12,517
Financial liabilities
Deposits		676,955		672,530		674,337		669,408
Federal funds purchased and securities
sold under agreements to repurchase		812		812		704		704
Borrowings		3,952		3,937		7,571		7,499

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Assets and liabilities measured at fair value on a recurring basis are as follows:

(in thousands)
	June 30, 2011
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Available-for-sale securities:
U.S. government agencies	$	-	$	7,139	$	-
Government-sponsored enterprises		-		41,310		-
Mortgage-backed securities		-		109,255		-
Total	$	-	$	157,704	$	-



	December 31, 2010
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Available-for-sale securities:
U.S. government agencies	$	-	$	5,323	$	-
Government-sponsored enterprises		-		44,039		-
Mortgage-backed securities		-		81,052		-
Total	$	-	$	130,414	$	-

The Company had no liabilities carried at fair value or measured at fair value on a recurring basis at June 30, 2011 or December 31, 2010.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Assets measured at fair value on a nonrecurring basis are included in the following table. Impaired loans are shown net of the related allowance for loan losses.

(in thousands)
	June 30, 2011
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Impaired loans:
Construction and development	$	-	$	27,244	$	-
1-4 family residential		-		12,235		-
Nonfarm, non residential		-		22,145		-
Total impaired real estate loans				61,624
Commercial and industrial		-		6,075		-
Consumer		-		-		-
Total impaired loans		-		67,699		-
Mortgage loans held for sale		-		3,746		-
Foreclosed real estate		-		8,255
Investment in real estate partnership		-		6,356
Total	$	-	$	86,056	$	-


	December 31, 2010
	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)

Impaired loans:
Construction and development	$	-	$	39,844	$	-
1-4 family residential		-		18,383		-
Nonfarm, non residential		-		23,989		-
Total impaired real estate loans				82,216
Commercial and industrial		-		6,493		-
Consumer		-		4		-
Total impaired loans		-		88,713		-
Mortgage loans held for sale		-		11,026		-
Foreclosed real estate		-		7,314
Total	$	-	$	107,053	$	-

The Company had no liabilities carried at fair value or measured at fair value on a nonrecurring basis at June 30, 2011 or December 31, 2010.

The Company is predominantly an asset-based lender with real estate serving as collateral on a substantial majority of loans. Loans which are deemed to be impaired are primarily valued on a nonrecurring basis at the fair values of the underlying real estate collateral. Such fair values are obtained using independent appraisals, which the Company considers to be Level 2 inputs.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Real estate acquired in settlement of loans is adjusted to fair value upon transfer of the loans. Subsequently, the assets are carried at the lower of carrying value or fair value less costs to sell. Fair value is based upon independent market prices, fair values of the collateral or management’s estimation of the value of the collateral. When the fair value of the collateral is based on an observable market price or current appraised value, the Company records the asset as nonrecurring Level 2 inputs.

Mortgage loans held for sale are carried at the lower of cost or fair value. The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics and accordingly, considered nonrecurring Level 2 inputs.

There were no transfers of assets measured at fair value between Level 1 and Level 2 measurements during the first half of 2011.

The Company has no assets or liabilities whose fair values are measured using Level 3 inputs.

Note 17 – Stockholders’ Equity

Preferred Stock

In November 2008, under the U.S. Department of the Treasury (Treasury) TARP Capital Purchase Program (CPP), the Company issued to the Treasury 16,369 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A (Preferred Stock), and a 10-year warrant to purchase up to 276,815 shares of common stock at an exercise price of $8.87 per share (Warrant), for aggregate proceeds of $16,369,000. The allocated carrying values of the Warrant and the Preferred Stock on the date of issuance (based on their relative fair values) were $1,016,000 and $15,353,000, respectively. Cumulative dividends on the Preferred Stock are payable at 5% per annum through November 14, 2013, and at a rate of 9% per annum thereafter. The Preferred Stock will be accreted to the redemption price of $16,369,000 over five years. The Warrant is exercisable at any time until November 14, 2018, and the number of shares of common stock underlying the Warrant and the exercise price are subject to adjustment for certain dilutive events.

Each share of Preferred Stock issued and outstanding has a liquidation preference of $1,000 and is redeemable at the Company’s option, subject to the approval of the Federal Reserve Bank, at a redemption price equal to $1,000 plus accrued and unpaid dividends.

The Preferred Stock has a preference over the Company’s common stock upon liquidation. Dividends on the Preferred Stock, if declared, are payable quarterly in arrears. The Company’s ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, its common stock is subject to certain restrictions in the event the Company fails to pay or set aside full dividends on the preferred stock for the latest completed dividend period. In addition, pursuant to the Treasury’s CPP, until at the earliest of November 14, 2011, or the redemption of all of the Preferred Stock or transfer by the Treasury of all of the Preferred Stock to third parties, the Company must obtain the consent of the Treasury to raise its common stock dividend or to repurchase any shares of common stock or other preferred stock, with certain exceptions.

Due to insufficient funding at the holding company level and restrictions placed on it under the Consent Order and the Written Agreement, the Company has deferred the payment of the last four quarterly dividends on the Preferred Stock, with the total amount deferred equaling $818,000 as of June 30, 2011. Until the Company pays in full these deferred Preferred Stock dividends, no dividends may be paid on the common stock.

Restriction on Dividends

As a North Carolina banking corporation, the Company may pay cash dividends only out of undivided profits as determined pursuant to North Carolina banking laws. However, regulatory authorities may limit payment of dividends when it is determined that such a limitation is in the public interest and is necessary to ensure a bank’s financial soundness. As discussed in Note 2, the Bank and the Company are restricted from paying dividends without the approval of the banking regulators.

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2011

Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory (and possibly additional discretionary) actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets, as all those terms are defined in the applicable regulations.

As of June 30, 2011, the most recent notification from the Bank’s primary regulator categorized the Bank as “adequately-capitalized” under the regulatory framework for prompt corrective action. Since that date, no conditions or events have occurred of which we are aware, that have resulted in a material change in the Company’s or the Bank’s category.

The table below summarizes the Company and the Bank’s capital ratios.

									To be "Well Capitalized"
					For Capital Adequacy				Under Prompt Corrective
	Actual				Purposes				Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio

As of June 30, 2011
Total Capital (to Risk-weighted Assets)
Company	$	37,948		8.26%	$	36,736		8.00%		n/a		n/a
Bank		37,926		8.26%	$	36,736		8.00%	$	45,919		10.00%
Tier I Capital (to Risk-weighted Assets)
Company	$	32,133		7.00%	$	18,368		4.00%		n/a		n/a
Bank		32,111		6.99%	$	18,368		4.00%	$	27,552		6.00%
Tier I Capital (to Average Assets)
Company	$	32,133		4.51%	$	28,478		4.00%		n/a		n/a
Bank		32,111		4.51%	$	28,479		4.00%	$	35,598		5.00%

As of December 31, 2010
Total Capital (to Risk-weighted Assets)
Company	$	38,410		8.04%	$	38,242		8.00%		n/a		n/a
Bank		38,397		8.03%		38,237		8.00%	$	47,796		10.00%
Tier I Capital (to Risk-weighted Assets)
Company	$	32,308		6.76%	$	19,121		4.00%		n/a		n/a
Bank		32,297		6.76%		19,119		4.00%	$	28,679		6.00%
Tier I Capital (to Average Assets)
Company	$	32,308		4.30%	$	30,060		4.00%		n/a		n/a
Bank		32,297		4.30%		30,057		4.00%	$	37,571		5.00%

The Consent Order requires the Bank to have and maintain Tier I Capital in such an amount as to equal or exceed 8% of the Bank’s total assets and total risk-based capital in such an amount as to equal or exceed 12% of the Bank’s total risk-weighted assets. We continue to consider plans to secure an equity infusion. Given the state of equity markets currently, our ability to raise capital in the foreseeable future is unknown. If additional equity cannot be secured, or can only be secured at an unexpectedly high cost, this could adversely affect the Company and the Bank.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

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

Introduction

1st Financial Services Corporation (the “Company”) is a North Carolina corporation headquartered in Hendersonville, North Carolina that when it was formed in May 2008 became the sole owner of all of the capital stock of Mountain 1st Bank & Trust Company (the “Bank”). The Bank is a North Carolina state-chartered, non-member bank, which was organized and incorporated under the laws of the State of North Carolina on April 30, 2004, and began operations on May 14, 2004. Currently, the Bank conducts business through 12 full-service branch offices located in nine Western North Carolina counties.

Because the Company has no separate operations and conducts no business on its own other than owning the Bank, the discussion contained in this Management’s Discussion and Analysis concerns primarily the business of the Bank. However, because the financial statements are presented on a consolidated basis, the Company and the Bank are collectively referred to herein as the “Company” unless otherwise noted.

The Bank competes for loans and deposits throughout the markets it serves. The Bank, like other financial institutions, derives most of its revenue from net interest income, which is the difference between the income it earns from loans and securities minus the interest expense it incurs on deposits and borrowings.

Management has provided the following discussion and analysis to address information about the Company’s financial condition and results of operations which may not otherwise be apparent from the consolidated financial statements included in this Report. Reference should be made to those statements for an understanding of the following discussion and analysis. The following discussion and analysis should be read in conjunction with the consolidated financial statements and the notes thereto located herein and in the Company’s filing on Form 10-K for the year ended December 31, 2010.

Factors That May Affect Future Results

The following discussion contains certain forward-looking statements about the Company’s financial condition and results of operations, which are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Those statements may be identified by the use of terms such as “may,” “will,” “should,” “could,” “plans,” “intends,” “anticipates,” “expects”, “believes,” “estimates,” “predicts,” “forecasts,” “potential” or “continue,” or similar terms or the negative of these terms, or other statements concerning opinions or judgments of our management about future events. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s judgment only as of the date hereof. The Company undertakes no obligation to publicly revise these forward-looking statements to reflect events and circumstances that arise after the date hereof. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) the impact of the extensive reforms enacted in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), the precise nature, extent and timing of many of these reforms and the impact on us is still uncertain; (2) competitive pressure among depository institutions increases significantly; (3) further credit quality deterioration which could cause an increase in the provisions for loan losses; (4) general economic conditions, particularly those affecting real estate values, either nationally or in the market area in which we do or anticipate doing business, are worse than expected; (5) regulatory limitations or prohibitions with respect to the operations or activities of the Company and/or the Bank; (6) revenues are lower than expected; (7) the availability of and/or an unexpectedly high cost of additional capital; (8) the effects of the Federal Deposit Insurance Corporation (FDIC) deposit insurance premiums and assessments; (9) the effects of and changes in monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board; (10) volatility in the credit or equity markets and its effect on the general economy; (11) demand for the products or services of the Company, as well as its ability to attract and retain qualified people; (12) our failure to meet the capital ratio requirements in the Stipulation to the Issuance of Consent Order (the Stipulation) agreeing to the issuance of a Consent Order (the Consent Order) with the FDIC and the North Carolina Commissioner of Banks (the Commissioner); (13) our failure to comply with the terms of the Written Agreement (the Written Agreement) between the Company and the Federal Reserve Bank of Richmond (the Federal Reserve Bank), including but not limited to the requirement to submit written capital plans to the Federal Reserve Bank; (14) the effect of other requirements in the Consent Order and the Written Agreement to which we are subject and any further regulatory actions; (15) the costs and effects of legal, accounting and regulatory developments and compliance, including the Consent Order and the Written Agreement; and (16) premiums for D&O insurance may increase: we may be unable to renew our D&O insurance policy on acceptable terms. See also those risk factors identified in the section headed “Risk Factors”, beginning on page 22 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2010, filed with the SEC on April 14, 2011 (the “Annual Report”). The Company undertakes no obligation to update any forward-looking statement, whether written or oral, which may be made from time to time by or on behalf of the Company.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Enforcement Policies and Actions

Federal law gives the FDIC substantial powers to enforce compliance with laws, rules, and regulations. Banks or individuals may be ordered to cease and desist from violations of law or other unsafe and unsound practices. The agency has the power to impose civil money penalties against individuals or institutions for certain violations.

Persons who are affiliated with depository institutions can be removed from any office held in that institution and banned from participating in the affairs of any financial institution. The banking regulators frequently employ the enforcement authorities provided in federal law.

During the first quarter of 2010, the Bank entered into the Stipulation agreeing to the issuance of the Consent Order with the FDIC and the Commissioner. Although the Bank neither admitted nor denied any unsafe or unsound banking practices or violations of law or regulation, it agreed to the Consent Order, which requires the Bank or its Board of Directors to undertake a number of actions including implementing plans to improve documentation regarding risk management and compliance systems, oversight and review functions, operating and financial management and capital plans. As a result, the Company expects to continue its focus on improving asset quality and profitability until capital levels increase.

As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, in October 2010, the Company entered into the Written Agreement with the Federal Reserve Bank.

As of June 30, 2011, the Company did not comply with a number of material terms of the Consent Order and the Written Agreement, including the enhanced capital requirements.

Regulatory Reform

The Dodd-Frank Act was signed into law on July 21, 2010. The Act is a significant piece of legislation that will have major effects on the financial services industry, including the organization, financial condition and operations of banks and bank holding companies. Management is currently evaluating the impact of the Act and rules that have been promulgated under the Act; however, uncertainty remains as to its operational impact, which could have a material adverse impact on the Company’s business, results of operations and financial condition. Many of the provisions of the Act are aimed at financial institutions that are significantly larger than the Company and the Bank. Notwithstanding this, there are many other provisions that the Company and the Bank are subject to and will have to comply with, including any new rules applicable to the Company and the Bank promulgated by the Bureau of Consumer Financial Protection, a new regulatory body dedicated to consumer protection. As rules and regulations continue to be published by the agencies responsible for implementing and enforcing the Act, the Company and the Bank will have to address each to ensure compliance with applicable provisions of the Act and compliance costs are expected to increase.

Critical Accounting Policies and Estimates

General . The Company’s accounting and financial reporting policies are in conformity, in all material respects, to accounting principles generally accepted in the U.S. and to general practices within the financial services industry. The preparation of financial statements in conformity with such principles requires management to make estimates and assumptions that impact the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities during the reporting period, and the reported amounts of income and expense during the reporting period.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

While we base estimates on historical experience, current information, and other factors deemed to be relevant, actual results could differ from those estimates. Management, in conjunction with the Company’s independent registered public accounting firm, has discussed the development and selection of the critical accounting estimates discussed herein with the Audit Committee of our Board of Directors.

We consider accounting policies and estimates to be critical to our financial condition, results of operations, or cash flows if the accounting policy or estimate requires management to make assumptions about matters that are highly uncertain and for which different estimates that management reasonably could have used for the accounting estimate in the current period, or changes in the accounting estimate that are reasonably likely to occur from period to period, could have a material impact on our financial condition, results of operations, or cash flows.

Our significant accounting policies are discussed in Note 1 to the audited consolidated financial statements for the year ended December 31, 2010, contained in the Company’s Annual Report. Of those significant accounting policies, we have determined that accounting for our allowance for loan losses, foreclosed real estate, the realization of our deferred tax asset, and the determination of fair value of financial instruments are deemed critical because of the valuation techniques used and the sensitivity of the amounts recorded in our consolidated financial statements to the methods, assumptions, and estimates underlying these balances. Accounting for these critical areas requires subjective and complex judgments and could be subject to revision as new information becomes available. Reference should be made to the Annual Report for a detailed discussion of these critical accounting policies.

General Economic Conditions

Western North Carolina is undergoing one of the most severe economic recessions in our history. Unemployment is at record levels and both residential and commercial real estate values have been adversely impacted. With the slowing economy, falling real estate values and reducing interest rates, our Company experienced severe stress on our earnings from both depressed margins and worsening asset quality. These conditions led to our providing an increase to the allowance for loan losses of $29.9 million in 2009 and suffering a net loss in 2009 of $18.6 million. During 2010, the Company recorded a $12.5 million provision for loan losses and incurred a net loss of $5.3 million. Continued weakness in the Western North Carolina real estate markets was the primary reason for the Bank’s increased provision for loan losses and loan charge-offs in 2010. Although we have experienced some margin improvement and expect to see further improvement through the remainder of 2011, we also expect to incur increased expense as we manage our troubled assets. Although we were profitable on a pre-provision, pre-tax basis in the first half of 2011, our markets continue to feel the effects of the recession and we do not foresee substantial improvements in either unemployment or real estate values until early 2012, at the earliest.

Overview

The Company’s primary market area is located in the mountain region of southwestern North Carolina. The principal business sectors in this region include service companies directly or indirectly linked to tourism, which is one of the largest economic drivers of the region, small to mid-sized manufacturing companies, real estate development, particularly relating to the ongoing growth of the area as a retirement and second home destination, the arts and crafts industry, and to a lesser degree, agriculture.

The Company believes its current base of business is relatively well diversified as is the general economic base of the region as a whole. The principal concentration identified by management within the Company’s lending portfolio is in loans secured by real estate. At June 30, 2011, loans collateralized by real estate, comprise 86.5% of the Company’s total loan portfolio. Management believes concentration risk within this sector of the loan portfolio is mitigated by the mix of different types of real estate held as collateral. These include residential, multifamily and both income-producing and owner-occupied commercial properties. The Company’s loan portfolio includes $105.6 million in loans classified as construction or acquisition and development (of which $46.2 million are land loans) and $170.2 million in loans classified as commercial real estate (CRE), representing 22.9% and 37.0%, respectively of the total portfolio. By way of comparison, at December 31, 2010, the Company’s loan portfolio included $114.5 million in loans classified as construction or acquisition and development (of which $49.9 million were land loans) and $173.3 million in loans classified as CRE, representing 23.6% and 35.6%, respectively of the total portfolio.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans with high loan-to-value ratios. At June 30, 2011, loans exceeding regulatory loan-to-value guidelines represented 92.4% of risk-based capital, primarily attributable to lower capital due to losses incurred in 2009 and 2010, combined with market value declines on the underlying collateral of the Bank’s real estate loan portfolio.

Banking regulators have continued to issue guidance to banks concerning their perception of general risk levels associated with higher concentrations of CRE as a proportion of total loans and as a percentage of capital within bank loan portfolios. It remains management’s understanding that regulatory interpretations of this guidance would not necessarily prohibit future growth for banks with concentrations of CRE, however, additional monitoring and risk management procedures are likely to be required for portfolios with higher levels of CRE and additional CRE lending may also be curtailed. Management has continued efforts to refine enhanced monitoring systems pertaining to the Bank’s CRE portfolio, with particular emphasis on construction and acquisition and development lending, which comprises a material portion of the Bank’s CRE portfolio. In addition to continued enhanced monitoring of this portion of the loan portfolio, management has curtailed lending to new acquisition and development projects and anticipates this component of the portfolio to decline substantially over time.

For the first five years of operation, management’s business plan had been predicated upon the relatively rapid growth and establishment of an initial branch network within the Company’s primary delineated market area. However, due to the current economic environment, management does not expect to continue to open new branch offices to augment the current branch network for the foreseeable future and may close certain offices to improve operating efficiencies. Instead, management will focus on its nonperforming loan portfolio and its other real estate owned, while simultaneously growing existing branches in its primary markets.

The Company’s primary source of revenue is derived from interest income produced through traditional banking activities such as generating loans and earning interest on securities. Additional sources of income are derived from fees on deposit accounts, Small Business Administration (“SBA”) and U.S. Department of Agriculture (“USDA”) loan originations and sales, and residential mortgage origination services.

Maintaining sound asset quality is another key focal point for the Company. As a result of the current economic environment, the Bank experienced an increase in nonperforming assets (nonaccruing loans and accruing loans past due 90 or more days) beginning in 2009, which resulted in a significant increase in our allowance for loan losses. This development is further discussed under the heading “Asset Quality” below. The business of lending to small businesses and consumers carries with it significant credit risks, which must be continually managed. Management monitors asset quality and credit risk on an ongoing basis and fully expects to experience credit losses in the future, but we believe we have made substantial progress in identifying and quantifying the impact of the current economic environment on our loan portfolio and overall financial condition. Management continues to engage third-party consultants to assist in monitoring and evaluating the quality of the portfolio.

Financial Overview

The Company’s total assets were $723.9 million at June 30, 2011, a decrease of $886,000, from $724.8 million at December 31, 2010. The Company’s total deposits were $677.0 million at June 30, 2011, an increase of $2.7 million, from $674.3 million at December 31, 2010. Proceeds from secondary market mortgage loan sales combined with loan repayments continue to boost cash on deposit with the Federal Reserve at quarter end, providing sufficient liquidity to fund investment security purchases, combined with providing liquidity to meet depositor needs. Overall growth plans have been purposely slowed in response to the Bank’s asset quality deterioration, uncertainties with respect to the national economy, regional and local real estate markets, the domestic interest rate environment and global currency markets and in order to maintain satisfactory capital requirements. The Company expects declines in total assets throughout the remainder of 2011 as $33.1 million in brokered certificates of deposit mature and are not renewed, including $10.6 million in the third quarter and $22.5 million in the fourth quarter and believes it has sufficient liquidity on hand to support funding at maturity.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Investment securities climbed by $28.5 million, or 21.4%, from $133.2 million at December 31, 2010, to $161.7 million at June 30, 2011. During the first six months of 2011, gross loans, excluding loans held for sale, decreased by $25.8 million, or 5.3%, from $486.2 million at December 31, 2010 to $460.4 million at June 30, 2011, as management purposely slowed loan growth in response to current economic conditions. During the same period, deposits increased by $2.6 million to $677.0 million on June 30, 2011, compared with $674.3 million at the end of 2010. The Company’s loan-to-asset ratio decreased from 67.1% at December 31, 2010, to 63.6% at June 30, 2011, principally reflecting an increase in loan repayments over loan production.

During the first six months of 2011, the Company recorded net income of $94,000, compared to net income of $713,000 for the first half of 2010. Net interest income for the first six months of 2011 increased to $10.4 million, compared with $10.1 million for the first half of 2010, despite the adverse impact of nonaccrual loans and historically low interest rates. The Company’s net interest margin increased to 3.12%, compared with 2.61% for the first half of 2010, primarily as a result of higher levels of investment securities in the 2011 period as compared to higher levels of overnight funds in the 2010 period, combined with lower rates on deposits. Provision for loan losses were $2.8 million for the first half of 2011, compared to $1.0 million for the six month period ended June 30, 2010. The Company anticipates higher provisioning in future quarters if economic conditions do not improve, borrowers continue to experience financial difficulties and real estate values continue to decline. Noninterest income for the six months ended June 30, 2011 remained steady at $3.0 million, compared to $3.1 million recorded during the six month period ended June 30, 2010, which primarily includes income from service charges on deposit accounts and mortgage services revenue. Noninterest expense for the six months ended June 30, 2011 decreased to $10.8 million, compared to $11.1 million for the similar period in 2010. The decrease in noninterest expense was driven primarily by strong cost control efforts leading to declines in all operating expense categories, including salary and occupancy costs as a result of the closure of two branches in the first quarter of 2011 and lower deposit insurance premiums due to a decline in the Bank’s deposit base and lower assessment rates beginning in the second quarter of 2011. These cost savings were mostly offset by significantly higher problem asset management costs and holding costs of and losses on the sale of other real estate owned. The duration and severity of the current recession continue to have a substantial negative impact on the Company’s performance.

Loans

Net loans outstanding, excluding loans held for sale, were $448.6 million at June 30, 2011, compared to $470.0 million on December 31, 2010, a decrease of $21.4 million, or 4.6%. Before the allowance for loan losses, loans receivable decreased $25.8 million, or 5.3%, from $486.2 million at December 31, 2010, to $460.4 million at June 30, 2011. Following is a summary of loans, excluding loans held for sale.

(in thousands)
	June 30,			December 31,
	2011			2010
Real estate:
Construction and development	$	105,561		$	114,532
1-4 family residential		115,914			120,217
Multifamily		5,805			6,417
Farmland		952			965
Nonfarm, nonresidential		170,237			173,326
Total real estate loans		398,469			415,457
Commercial and industrial loans		58,269			66,254
Consumer		3,705			4,484
		460,443			486,195
Allowance for loan losses		(11,812	)		(16,191	)
Total	$	448,631		$	470,004

Of our outstanding loans, $22.8 million are attributable to loans purchased from Live Oak Bank, a de novo state chartered bank located in Eastern North Carolina. Live Oak Bank focuses on the origination and servicing of loans to small businesses, primarily small business loans guaranteed by the SBA. The Bank has worked with Live Oak Bank since its inception to originate loans. Although the Company may purchase additional loans, the Bank also originates, services, and sells USDA and SBA loans on its own. We expect to continue originating both SBA and USDA loans and management feels this will positively impact future earnings.

Management expects loan growth will continue to be muted during the remainder of 2011 and into early 2012 as a result of the economic uncertainties that are expected to persist for the foreseeable future.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Deposits

Total deposits at June 30, 2011 were $677.0 million, up slightly from $674.3 million on December 31, 2010. During the first six months of 2011, demand deposits increased $5.8 million, money market accounts increased $2.5 million and savings deposits increased $14.0 million, while interest-bearing checking accounts declined by $2.5 million and certificates of deposits declined by $17.3 million. Through our branch network, the Bank continues to attract new depository customers seeking value-added service. In addition to attracting new core deposit customers, our existing customers, in this low interest rate environment, are exhibiting a preference to maintaining their funds in short-term liquid investments, such as our savings and money market deposit accounts. As a consequence, customers are often taking the funds from maturing certificates and depositing them into savings, checking, and money market accounts. Some customers are also beginning to transfer their liquid funds back into the stock markets.

Borrowings

As of June 30, 2011, the Company had total borrowings of $4.8 million, compared to $8.3 million at December 31, 2010. Borrowings from the Federal Home Loan Bank decreased to $4.0 million, while securities sold under agreements to repurchase increased by $108,000. USDA loans of $3.6 million sold in the fourth quarter of 2010 were treated as secured borrowings at December 31, 2010. The sale was completed with de-recognition of the loans and the secured borrowing liability occurring after expiration of the 90-day guarantee period.

Stockholders’ Equity

Consolidated stockholders’ equity increased to $38.5 million at June 30, 2011, compared to $37.3 million at December 31, 2010, representing 5.3% and 5.2% of total assets for each period, respectively. The Company’s net income of $94,000 for the first six months of 2011 and a $1.1 million increase in net unrealized gains on available-for-sale securities, net of income taxes, were the primary factors contributing to the increase. Book value per common share was $4.37 at June 30, 2011, an increase of $0.14, compared to $4.23 per common share at December 31, 2010.

No cash dividends have been declared on common stock during 2011, and management does not anticipate cash dividends on common stock for the foreseeable future. Further, in February and May 2011, the Company deferred the $205,000 payment of cash dividends on its preferred stock. As of June 30, 2011, the Company has deferred payment of $818,000 in preferred dividends. The Company expects to again defer the $205,000 payment of the preferred dividend in August 2011, in order to preserve capital.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

As of June 30, 2011, the Bank’s primary federal regulator categorized the Bank as “adequately-capitalized” under the regulatory framework for prompt corrective action. Actual capital amounts and ratios for the Company and the Bank at June 30, 2011 and December 31, 2010 are presented in the following table.

(dollars in thousands)

									To be "Well Capitalized"
					For Capital Adequacy				Under Prompt Corrective
	Actual				Purposes				Action Provisions
	Amount		Ratio		Amount		Ratio		Amount		Ratio

As of June 30, 2011
Total Capital (to Risk-weighted Assets)
Company	$	37,948		8.26%	$	36,736		8.00%		n/a		n/a
Bank		37,926		8.26%		36,736		8.00%	$	45,919		10.00%
Tier I Capital (to Risk-weighted Assets)
Company	$	32,133		7.00%	$	18,368		4.00%		n/a		n/a
Bank		32,111		6.99%	$	18,368		4.00%	$	27,552		6.00%
Tier I Capital (to Average Assets)
Company	$	32,133		4.51%	$	28,478		4.00%		n/a		n/a
Bank		32,111		4.51%		28,479		4.00%	$	35,598		5.00%

As of December 31, 2010
Total Capital (to Risk-weighted Assets)
Company	$	38,410		8.04%	$	38,242		8.00%		n/a		n/a
Bank		38,397		8.03%		38,237		8.00%	$	47,796		10.00%
Tier I Capital (to Risk-weighted Assets)
Company	$	32,308		6.76%	$	19,121		4.00%		n/a		n/a
Bank		32,297		6.76%		19,119		4.00%	$	28,679		6.00%
Tier I Capital (to Average Assets)
Company	$	32,308		4.30%	$	30,060		4.00%		n/a		n/a
Bank		32,297		4.30%		30,057		4.00%	$	37,571		5.00%

Asset Quality

Over the course of the past several years, credit quality has deteriorated as real estate markets have been hit with slowing sales and declining prices. The markets in which the Company operates have also been affected by such downturns. Although real estate prices in Western North Carolina have shown a downward trend, some early signs of potential stabilization have been noted. The longer the current real estate market downturn persists, the more vulnerable sales volume and prices become.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Although management believes the Company appropriately reserved for our problem assets at year-end 2010, we nonetheless continue to experience the effects of asset devaluation in our markets as the economy and businesses struggle to recover. We have allocated significant additional resources toward expeditious resolution of our nonperforming loans and those assets we have foreclosed upon. We anticipate additional provisioning and charge-offs during 2011 to stay ahead of this resolution process. As of June 30, 2011, nonperforming assets were $53.3 million, up $8.2 million from $45.1 million at December 31, 2010, principally due to the nonperforming asset classification of the $6.4 million investment in real estate partnership, as discussed below. As a percentage of period-end portfolio loans, other real estate owned and investment in real estate partnership, nonperforming assets were 11.23% at June 30, 2011, versus 9.14% at year-end 2010. The allowance for loan losses as a percentage of period-end portfolio loans stood at 2.57% at June 30, 2011, down from 3.33% at December 31, 2010, mainly reflecting $7.2 million in net charge-offs taken during the first half of 2011, for which $4.4 million of the related reserves were established at December 31, 2010. The adverse effect of the net charge-offs was partially offset by a decline in outstanding loan balances. Management expects the level of nonperforming assets to remain at elevated levels through the remainder of 2011. The Company has seen its level of loans 30-89 days past due decline significantly in recent months; however, there can be no assurance this trend will continue into the future. As of June 30, 2011, loans 30-89 days past due were $6.5 million, compared to $7.3 million at December 31, 2010 and $14.1 million at September 30, 2010, its highest level in the current credit cycle.

The provision for loan losses was $2.8 million for the first half of 2011, compared to $1.0 million for the 2010 first half, while net charge-offs were $7.2 million in the 2011 period, compared to net charge-offs of $8.6 million in the 2010 period. The charge-offs in each period resulted principally from recognition of losses previously reserved for as these loans were worked through the Bank’s asset resolution process. In addition, as part of this resolution process, management provides for additional losses through increases to its allowance for loan losses.

The following table provides additional information about the Bank’s nonperforming assets.

Nonperforming Assets
(dollars in thousands)
	June 30,			December 31,
	2011			2010

Nonaccrual loans	$	38,729		$	37,799
Loan past due 90 or more days and still accruing interest		-			5
Total nonperforming loans		38,729			37,804
Foreclosed real estate		8,255			7,314
Repossessed assets		-			7
Investment in real estate partnership		6,356			-
Total nonperforming assets	$	53,340		$	45,125

Allowance for loan losses	$	11,812		$	16,191

Nonperforming loans to period-end loans,
excluding loans held for sale		8.41	%		7.78	%

Allowance for loan losses to period-end loans,
excluding loans held for sale		2.57	%		3.33	%

Nonperforming assets as a percentage of:
Loans, foreclosed real estate and investment in real estate partnership		11.23	%		9.14	%
Total assets		7.37	%		6.23	%

Ratio of allowance for loan losses to nonperforming loans		30.5	%		42.8	%

Investment in Real Estate Partnership. During 2009, the Bank became a member in a limited liability corporation (LLC). The Bank contributed two nonperforming loans with an aggregate principal amount outstanding of $6.7 million to the LLC, while the other members contributed professional real estate development experience and cash sufficient to carry the properties’ operating costs for an extended period of time. The LLC is designed to hold the real estate until such time as market values return to normalized levels at which point it is anticipated that the properties will be marketed by seasoned real estate developers with the proceeds of the sale being distributed based on contractual formulas to members of the LLC. During 2010, the Bank received $311,000 as reduction of principal from the sale of a sub-parcel of one of the two properties. As of June 30, 2011 and December 31, 2010, the Bank’s investment in the LLC was $6.4 million.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Restructured Loans Accruing Interest. On a case-by-case basis, management determines whether an account that experiences financial difficulties should be modified as to its interest rate or repayment terms to maximize the Company’s collection of its balance. Loans restructured at a rate equal to or greater than that of a new loan with comparable risk at the time the contract is modified are excluded from restructured loans once repayment performance, in accordance with the modified agreements, has been demonstrated over several payment cycles. Loans that have interest rates reduced below comparable market rates remain classified as restructured loans; however, interest income is accrued at the reduced rate as long as the customer complies with the revised terms and conditions. Restructured loans totaled $9.0 million at June 30, 2011, compared to $9.4 million at December 31, 2010, of which $4.5 million were accruing interest at both respective periods.

Loan loss experience for the three and six months ended June 30, 2011 and 2010, is presented below.

(dollars in thousands)
	Three Months Ended June 30						Six Months Ended June 30
	2011			2010			2011			2010

Balance at beginning of period	$	13,905		$	25,691		$	16,191		$	28,231
Provision for loan losses		2,120			720			2,806			1,020
Charge-offs
Construction and development		959			4,579			3,055			5,569
1-4 family residential		1,258			349			1,555			1,688
Multifamily		-			-			-			184
Nonfarm, non residential		1,148			479			1,180			695
Total real estate		3,365			5,407			5,790			8,136
Commercial		850			245			1,423			527
Consumer		24			138			41			313
Total charge-offs		4,239			5,790			7,254			8,976
Recoveries
Construction and development		3			3			3			330
1-4 family residential		2			1			5			4
Nonfarm, non residential		-			4			-			4
Total real estate		5			8			8			338
Commercial		17			1			53			14
Consumer		4			2			8			5
Total recoveries		26			11			69			357
Net charge-offs		4,213			5,779			7,185			8,619
Balance at end of period	$	11,812		$	20,632		$	11,812		$	20,632
Average loans, excluding loans held for sale	$	475,409		$	529,270		$	478,571		$	539,059
Period end loans, excluding loans held for sale	$	460,443		$	515,462		$	460,443		$	515,462
Net charge-offs to average loans,
excluding loans held for sale (1)		3.55	%		4.38	%		3.03	%		3.22	%
Allowance for loan losses to period end loans,
excluding loans held for sale		2.57	%		4.00	%		2.57	%		4.00	%

(1) Annualized

Analysis of Allowance for Loan Losses

The level of the allowance for loan losses is established based upon management’s evaluation of portfolio composition, current and projected national and local economic conditions, and results of independent reviews of the loan portfolio by internal and external examination. Management recognizes the inherent risk associated with commercial and consumer lending, including whether or not a borrower’s actual results of operations will correspond to those projected by the borrower when the loan was funded; economic factors such as the number of housing starts and fluctuations in interest rates; possible further depression of collateral values; and completion of projects within the original cost and time estimates. As a result, management continues to actively monitor the Company’s asset quality and lending policies.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Management is currently making efforts to alter the composition of its loan portfolio so that a further downturn in a particular market or industry will not have a material impact on the loan portfolio as a whole or the Company’s financial condition. Given the current condition of the real estate markets in the Company’s footprint, real estate loans have been significantly curtailed. The Company continues to focus its lending effort toward providing credit to small businesses and consumers who are creditworthy.

Management has taken what it believes to be an aggressive stance on identifying problems with credits and placing them on nonaccruing status relatively early in its evaluation process. In addition, management has evaluated these credits and their ultimate collectability using both internal and external portfolio loan reviews, and believes any potential losses which may be incurred on these credits in the future are incorporated into its analysis of the adequacy of the Bank’s existing allowance for loan losses.

We calculate our general allowance by applying our historical loss factors to each sector of the loan portfolio. For consistency of comparison on a quarterly basis, we use a rolling eight-quarter look-back period when computing historical loss rates.

We adjust these historical loss percentages for qualitative environmental factors derived from macroeconomic indicators and other factors. Qualitative factors we considered in the determination of the June 30, 2011, allowance for loan losses include pervasive factors that generally impact borrowers across the loan portfolio (such as unemployment and consumer price index) and factors that have specific implications to particular loan portfolios (such as residential home sales or commercial development). Factors evaluated may include changes in delinquent, nonaccrual and troubled debt restructured loan trends, trends in risk ratings and net loans charged-off, concentrations of credit, competition and legal and regulatory requirements, trends in the nature and volume of the loan portfolio, national and local economic and business conditions, collateral valuations, the experience and depth of lending management, lending policies and procedures, underwriting standards and practices, the quality of loan review systems and degree of oversight by the Board of Directors, and other external factors. The general reserve calculated using the historical loss rates and qualitative factors is then combined with the specific allowance on loans individually evaluated for impairment to determine the total allowance for loan losses.

Portions of the allowance for loan losses may be allocated for specific loans or portfolio segments. However, the entire allowance for loan losses is available for any loan that, in our judgment, should be charged-off. In addition to our portfolio review process, various regulatory agencies periodically review our allowance for loan losses. These agencies may require us to recognize additions to the allowance for loan losses based on their judgments and information available to them at the time of their examinations. While we use available information to recognize inherent losses on loans, future adjustments to the allowance for loan losses may be necessary based on changes in economic conditions and other factors and the impact of such changes and other factors on our borrowers.

We believe the allowance for loan losses at June 30, 2011, is appropriate and adequate to cover probable inherent losses in the loan portfolio. However, underlying assumptions may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers which was not known to us at the time of the issuance of our consolidated financial statements. Therefore, our assumptions may or may not prove valid. Thus, there can be no assurance that loan losses in future periods will not exceed the current allowance for loan losses amount or that future increases in the allowance for loan losses will not be required. Furthermore, while management believes it has established the allowance for loan losses in conformity with generally accepted accounting principles, there can be no assurance that regulators, in reviewing our portfolio, will not require adjustment to the allowance for loan losses. Additionally, no assurance can be given that our ongoing evaluation of the loan portfolio, in light of changing economic conditions and other relevant factors, will not require significant future additions to the allowance for loan losses, thus adversely impacting our business, financial condition, results of operations, and cash flows.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

The following table presents the allocation of the allowance for loan losses. The allocation is based on an evaluation of defined loan problems, historical ratios of loan losses, and other factors that may affect future loan losses in the categories of loans shown.

Allocation of the Allowance for Loan Losses
(dollars in thousands)
	June 30, 2011					December 31, 2010
			Percent					Percent
			of Total					of Total
	Amount		Loans (1)			Amount		Loans (1)

Construction loans	$	5,131		22.9	%	$	8,499		23.6	%
1-4 family residential		3,581		25.2			4,371		24.7
Multifamily		33		1.3			35		1.3
Farmland		13		0.2			12		0.2
Nonfarm, nonresidential		972		37.0			1,798		35.7
Total real estate loans		9,730		86.6			14,715		85.5
Commercial and industrial loans		2,019		12.6			1,412		13.6
Consumer		63		0.8			64		0.9
Total	$	11,812		100	%	$	16,191		100	%

(1) Percent of loans in each category to total loans

Impaired Loans. Loans for which it is probable that the ultimate payment of interest and principal will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management measures the impairment in accordance with generally accepted accounting principles. The fair value of impaired loans is estimated using one of several methods including collateral value, market value of similar debt, enterprise value, liquidation value, and discounted cash flows. Those impaired loans not requiring an allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investment in such loans. At June 30, 2011, substantially all of the total impaired loans were evaluated based on the fair value of the collateral. In accordance with ASC Topic 820, impaired loans where an allowance is established based on the fair value of collateral require classification in the fair value hierarchy. Collateral values for impaired loans are estimated using Level 2 inputs based on independent appraisals. As of June 30, 2011, impaired loans totaled $75.0 million. Allocations within the Bank’s allowance for loan losses specifically ascribed to these individual loans totaled $7.3 million.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Results of Operations

Three Months Ended June 30, 2011, Compared to the Three Months Ended June 30, 2010

Summary

The Company recorded a net loss of $508,000 for the second quarter of 2011, compared with net income of $365,000 for the same quarter in 2010. Net loss available to common stockholders, after the effect of preferred stock dividends, was $764,000 for the second quarter of 2011, or $0.15 per diluted share, compared with net income available to common shareholders of $109,000, or $0.02 per diluted share, in the year-ago quarter. The decrease in net income in 2011 second quarter was driven principally by higher provision for loan losses and lower noninterest income, partially offset by an increase in net interest income in comparison to the similar period in 2010.

Net Interest Income

Net interest income for the 2011 second quarter increased to $5.3 million, compared with $5.0 million for the second quarter of 2010, despite the adverse impact of nonaccrual loans and historically low interest rates. Although average earning assets declined $93.3 million between quarters, the Company’s net interest margin improved to 3.17%, from 2.65% for the second quarter of 2010. The significant margin improvement resulted from a 27 basis point increase in the average yield on earning assets to 4.30% due to a shift in the composition of the assets, and a 29 basis point reduction in the average cost of funds to 1.26%. The lower cost of funds was also due to a change in our mix of deposits. Despite quarter-over-quarter improvements in net interest margin, the Company’s decision to build and maintain a significant liquidity position in an uncertain regulatory and economic environment continues to have an adverse impact on the net interest margin. The net interest margin will also be negatively affected if the economic environment remains sluggish, loan originations slow further, and nonaccrual loans continue at higher levels.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

The following table illustrates the Company’s yield on earning assets and cost of funds for the three-month periods ended June 30, 2011 and 2010.

Average Balances and Net Interest Income
(dollars in thousands)
	Three Months Ended June 30
	2011								2010
	Average			Interest					Average			Interest
	Daily			Income/		Average			Daily			Income/		Average
	Balance			Expense(1)(2)		Rate(3)			Balance			Expense(1)(2)		Rate(3)
Interest-earning assets
Loans and loans held for sale	$	478,332		$	6,039		5.06	%	$	535,842		$	7,013		5.25	%
Investment securities		151,644			1,129		2.98	%		120,550			615		2.04	%
Due from Federal Reserve Bank		35,786			21		0.23	%		107,295			62		0.23	%
Interest-bearing bank deposits		6,563			22		1.28	%		1,902			4		0.89	%
Total interest-earning assets		672,325			7,211		4.30	%		765,589			7,694		4.03	%

Noninterest-earning assets:
Cash and due from banks		15,251								9,864
Property and equipment		5,523								5,214
Interest receivable and other		24,575								14,234
Total noninterest-earning assets		45,349								29,312
Total assets	$	717,674							$	794,901

Interest-bearing liabilities
NOW accounts		63,319			49		0.31	%		61,876			50		0.32	%
Money markets		50,295			133		1.06	%		46,219			143		1.25	%
Savings deposits		120,623			315		1.05	%		96,785			268		1.11	%
Time deposits		363,146			1,394		1.54	%		421,318			2,075		1.98	%
Federal funds purchased/repurchase agreements		880			1		0.44	%		968			1		0.69	%
Borrowings		3,951			6		0.79	%		51,319			93		0.71	%
Total interest-bearing liabilities		602,214			1,898		1.26	%		678,485			2,630		1.55	%

Noninterest-bearing liabilities:
Demand deposits		72,838								64,981
Interest payable and other		4,715								7,436
Total noninterest-bearing liabilities		77,553								72,417
Total liabilities		679,767								750,902

Stockholders' equity		37,907								43,999
Total liabilities and stockholders' equity	$	717,674							$	794,901


Net interest income and interest rate spread				$	5,313		3.04	%				$	5,064		2.48	%

Net yield on average interest-earning assets							3.17	%							2.65	%

Ratio of average interest-earning assets to
average interest-bearing liabilities		111.64	%							112.84	%

(1) Interest income includes amortization of deferred loan fees, net.
(2) Nonaccrual loans are included in gross loans but interest is not included in interest income.
(3) Annualized.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

The following table shows changes in interest income, interest expense, and net interest income arising from volume and rate changes for major categories of earning assets and interest-bearing liabilities. The change in interest not solely due to changes in volume or rates has been allocated in proportion to the absolute dollar change in both.

Volume and Rate Variance Analysis
(in thousands)
	Three Months Ended June 30									Three Months Ended June 30
	2011 vs 2010									2010 vs 2009
	Increase (Decrease) Due to									Increase (Decrease) Due to
	Volume			Rate			Total			Volume			Rate			Total
Interest income:
Loans, including loans held for sale	$	(733	)	$	(241	)	$	(974	)	$	(354	)	$	(707	)	$	(1,061	)
Investment securities		184			330			514			(257	)		239			(18	)
Federal funds sold		-			-			-			-			(2	)		(2	)
Due from Federal Reserve Bank		(43	)		2			(41	)		-			62			62
Interest-bearing bank deposits		15			3			18			-			-			-
Total interest income		(577	)		94			(483	)		(611	)		(408	)		(1,019	)

Interest expense:
NOW accounts	$	1		$	(2	)	$	(1	)	$	(5	)	$	2		$	(3	)
Money markets		12			(22	)		(10	)		(53	)		6			(47	)
Savings deposits		63			(16	)		47			(84	)		45			(39	)
Time deposits		(262	)		(419	)		(681	)		(562	)		449			(113	)
Federal funds purchased and securities
sold under agreements to repurchase		-			-			-			(1	)		(2	)		(3	)
Other borrowings		(62	)		(25	)		(87	)		60			2			62
Total interest expense		(248	)		(484	)		(732	)		(645	)		502			(143	)
Net increase (decrease) in net interest income	$	(329	)	$	578		$	249		$	34		$	(910	)	$	(876	)

Provisions for Loan Losses

Provisions for loan losses are charged to income to bring the allowance for loan losses to a level deemed appropriate by management. In evaluating the allowance for loan losses, management considers factors that include growth, composition, diversification, or conversely, concentrations by industry, geography or collateral within the portfolio, historical loan loss experience, current seasoning of the portfolio, current delinquency levels, adverse situations that may affect a borrower’s ability to repay, estimated value of any underlying collateral, prevailing economic conditions and other relevant factors.

Provision for loan losses for the three months ended June 30, 2011, totaled $2.1 million, an increase of $1.4 million from $720,000 for the comparable 2010 quarter. The Company anticipates higher provisioning in future quarters if economic conditions do not improve, borrowers continue to experience financial difficulties, and real estate values continue to decline.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Noninterest Income

Noninterest income for the three months ended June 30, 2011, totaled $1.4 million, compared with $1.8 million for the same quarter in 2010. The two primary components of noninterest income are income derived from mortgage loan originations and service charges on deposit accounts, which contributed $624,000 and $423,000, respectively, to noninterest income while other service charges, increases in the cash surrender value of bank-owned life insurance, and USDA/SBA loan sale and servicing revenue contributed $152,000, $112,000, and $12,000, respectively during the quarter ending June 30, 2011. During the same period in 2010, income derived from mortgage loan originations of $495,000 and service charges on deposits in the amount of $579,000 were the major components of noninterest income, while other service charges, increases in the cash surrender value of bank-owned life insurance, net gains on the sale of investment securities, and USDA/SBA loan sale and servicing revenue added $119,000, $117,000, $377,000, and $108,000 respectively, to noninterest income.

Noninterest Income
(in thousands)
	Three Months Ended June 30
	2011		2010
Service charges on deposit accounts	$	624	$	579
Mortgage services revenue		423		495
Other service charges and fees		152		119
Increase in cash surrender value of life insurance		112		117
Gain on sale of investment securities, net		-		377
USDA/SBA loan sale and servicing revenue		12		108
Other income		49		25
Total	$	1,372	$	1,820

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Noninterest Expense

Noninterest expense of $5.6 million for the second quarter of 2011 was relatively unchanged in total from the 2010 second quarter. Strong cost control efforts leading to declines in most operating expense categories, including salary and occupancy costs as a result of the closure of two branches in the first quarter of 2011 and lower deposit insurance premiums due to a decline in the Company’s deposit base and a lower assessment rate beginning in the second quarter of 2011 were offset by significantly higher problem asset management costs, principally appraisal and legal fees, and holding costs of and losses on the sale of other real estate owned. The duration and severity of the current recession continue to have a substantial negative impact on the Company’s performance.

Noninterest Expense
(in thousands)
	Three Months Ended June 30
	2011		2010
Salaries and employee benefits	$	2,106	$	2,675
Occupancy		219		423
Equipment		240		315
Advertising		76		124
Data processing and telecommunications		525		504
Deposit insurance premiums		408		420
Professional fees		74		326
Printing and supplies expense		37		66
Dues and subscriptions		47		47
Postage		44		22
Foreclosed real estate		411		167
Loss on sale of repossessed assets		2		9
Debt extinguishment expense		-		66
Loan legal		115		122
Loan appraisal		58		9
Other loan related expense		972		6
Corporate insurance		56		28
Other		211		302
Total	$	5,601	$	5,631

During the second quarter of 2011, the Company recorded income tax benefit of $528,000 based on a pre-tax book loss of $1.0 million. For the second quarter of 2010, the Company recorded income tax expense of $168,000 based on pre-tax book income of $533,000.

Six Months Ended June 30, 2011, Compared to the Six Months Ended June 30, 2010

Summary

The Company recorded net income of $94,000 for the six months ended June 30, 2011, compared with net income of $713,000 for the six months ended June 30, 2010. Net loss available to common stockholders, after the effect of preferred stock dividends, was $416,000 for the six months ended June 30, 2011, or $0.08 per diluted share, a reduction of $619,000, or $0.12 per diluted share, compared with net income available to common shareholders of $203,000, or $0.04 per diluted share, in the comparable 2010 period. The decrease in net income in 2011 was driven principally by a higher provision for loan losses despite an improvement in net interest income and a reduction in noninterest expense due to cost control efforts.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Net Interest Income

Net interest income for the six month period of 2011 increased to $10.4 million, compared with $10.1 million for the comparable six month period of 2010, despite the adverse impact of nonaccrual loans and historically low interest rates. Although average earning assets declined $106.5 million between periods, the Company’s net interest margin improved to 3.12%, from 2.61% for the 2010 period. The significant margin improvement resulted from a 29 basis point increase in the average yield on earning assets to 4.30% due to a shift in the composition of the assets, and a 27 basis point reduction in the average cost of funds to 1.32%. The lower cost of funds was also due to a change in our mix of deposits. Despite year-over-year improvements in net interest margin, the Company’s decision to build and maintain a significant liquidity position in an uncertain regulatory and economic environment, continues to have an adverse impact on the net interest margin. The net interest margin will also be negatively affected if the economic environment remains sluggish, loan originations slow further, and nonaccrual loans continue at higher levels. Net interest income is anticipated to remain flat in 2011, compared to 2010.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

The following table illustrates the Company’s yield on earning assets and cost of funds for the six-month periods ended June 30, 2011 and 2010.

Average Balances and Net Interest Income
(dollars in thousands)
	Six Months Ended June 30
	2011								2010
	Average			Interest					Average			Interest
	Daily			Income/		Average			Daily			Income/		Average
	Balance			Expense(1)(2)		Rate(3)			Balance			Expense(1)(2)		Rate(3)
Interest-earning assets
Loans and loans held for sale	$	482,082		$	12,121		5.07	%	$	543,884		$	14,188		5.26	%
Investment securities		146,553			2,142		2.92	%		111,648			1,158		2.07	%
Due from Federal Reserve Bank		36,255			42		0.23	%		121,433			141		0.23	%
Interest-bearing bank deposits		6,519			40		1.23	%		983			4		0.87	%
Total interest-earning assets		671,409			14,345		4.30	%		777,948			15,491		4.01	%

Noninterest-earning assets:
Cash and due from banks		15,525								9,943
Property and equipment		5,658								5,526
Interest receivable and other		23,659								9,486
Total noninterest-earning assets		44,842								24,955
Total assets	$	716,251							$	802,903

Interest-bearing liabilities
NOW accounts		63,113			96		0.31	%		61,008			102		0.34	%
Money markets		49,338			264		1.08	%		44,811			295		1.33	%
Savings deposits		116,977			611		1.05	%		93,373			514		1.11	%
Time deposits		368,651			2,950		1.61	%		428,575			4,249		2.00	%
Federal funds purchased/repurchase agreements		873			3		0.80	%		1,005			3		0.68	%
Borrowings		3,952			17		0.44	%		60,608			272		0.91	%
Total interest-bearing liabilities		602,904			3,941		1.32	%		689,380			5,435		1.59	%

Noninterest-bearing liabilities:
Demand deposits		70,682								63,276
Interest payable and other		5,075								6,209
Total noninterest-bearing liabilities		75,757								69,485
Total liabilities		678,661								758,865

Stockholders' equity		37,590								44,038
Total liabilities and stockholders' equity	$	716,251							$	802,903


Net interest income and interest rate spread				$	10,404		2.98	%				$	10,056		2.42	%

Net yield on average interest-earning assets							3.12	%							2.61	%

Ratio of average interest-earning assets to
average interest-bearing liabilities		111.36	%							112.85	%

(1) Interest income includes amortization of deferred loan fees, net.
(2) Nonaccrual loans are included in gross loans but interest is not included in interest income.
(3) Annualized.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Volume and Rate Variance Analysis
(in thousands)
	Six Months Ended June 30									Six Months Ended June 30
	2011 vs 2010									2010 vs 2009
	Increase (Decrease) Due to									Increase (Decrease) Due to
	Volume			Rate			Total			Volume			Rate			Total
Interest income:
Loans, including loans held for sale	$	(1,568	)	$	(499	)	$	(2,067	)	$	(560	)	$	(1,123	)	$	(1,683	)
Investment securities		426			558			984			(753	)		370			(383	)
Federal funds sold		-			-			-			-			(4	)		(4	)
Due from Federal Reserve Bank		(99	)		-			(99	)		-			141			141
Interest-bearing bank deposits		33			3			36			-			-			0
Total interest income		(1,208	)		62			(1,146	)		(1,313	)		(616	)		(1,929	)

Interest expense:
NOW accounts	$	3		$	(9	)	$	(6	)	$	(12	)	$	7		$	(5	)
Money markets		28			(59	)		(31	)		(80	)		30			(50	)
Savings deposits		124			(27	)		97			(165	)		83			(82	)
Time deposits		(546	)		(753	)		(1,299	)		(1,560	)		982			(578	)
Federal funds purchased and securities
sold under agreements to repurchase		(1	)		1			-			(1	)		(3	)		(4	)
Other borrowings		(167	)		(88	)		(255	)		182			9			191
Total interest expense		(559	)		(935	)		(1,494	)		(1,636	)		1,108			(528	)
Net increase (decrease) in net interest income	$	(649	)	$	997		$	348		$	323		$	(1,724	)	$	(1,401	)

Provisions for Loan Losses

Provision for loan losses for the six months ended June 30, 2011, totaled $2.8 million, an increase of $1.8 million from $1.0 million for the comparable six months ended June 30, 2010. The Company anticipates higher provisioning in future quarters if economic conditions do not improve, borrowers continue to experience financial difficulties, and real estate values continue to decline.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Noninterest Income

Noninterest income for the six months ended June 30, 2011, totaled $3.0 million, compared with $3.1 million for the six months ended June 30, 2010. The two primary components of noninterest income are income derived from mortgage loan originations and service charges on deposit accounts, which contributed $993,000 and $1.2 million, respectively, to noninterest income while other service charges, increases in the cash surrender value of bank-owned life insurance, and USDA/SBA loan sales and servicing revenue contributed $299,000, $219,000, and $224,000, respectively during the six months ended June 30, 2011. During the same period in 2010, income derived from mortgage loan originations of $818,000 and service charges on deposits in the amount of $1.1 million were the major components of noninterest income, while other service charges, increases in the cash surrender value of bank-owned life insurance, net gains on the sale of investment securities and USDA/SBA loan sales and servicing revenue added $230,000, $230,000, $500,000, and $129,000 respectively, to noninterest income.

For the full year 2011, mortgage service revenue is projected to decrease, compared to 2010. USDA/SBA loan sale and servicing revenue is anticipated to decrease in 2011, compared to 2010. Securities gains are projected to be nominal in 2011.

Noninterest Income
(in thousands)
	Six Months Ended June 30
	2011		2010
Service charges on deposit accounts	$	1,215	$	1,114
Mortgage services revenue		993		818
Other service charges and fees		299		230
Increase in cash surrender value of life insurance		219		230
Gain on sale of investment securities, net		-		500
USDA/SBA loan sale and servicing revenue		224		129
Other income		78		30
Total	$	3,028	$	3,051

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Noninterest Expense

Noninterest expense of $10.8 million for the first half of 2011 was $236,000 lower than noninterest expense of $11.1 million in the first half of 2010. The decrease in noninterest expense was driven primarily by strong cost control efforts leading to declines in all operating expense categories, including salary and occupancy costs as a result of the closure of two branches in the first quarter of 2011 and lower deposit insurance premiums due to a decline in the Company’s deposit base and a lower assessment rate beginning in the second quarter of 2011. These cost savings were partially offset by significantly higher problem asset management costs, principally appraisal and legal fees, and holding costs of and losses on the sale of other real estate owned. The duration and severity of the current recession continue to have a substantial negative impact on the Company’s performance.

Noninterest Expense
(in thousands)
	Six Months Ended June 30
	2011		2010
Salaries and employee benefits	$	4,458	$	5,131
Occupancy		587		839
Equipment		485		639
Advertising		128		272
Data processing and telecommunications		1,036		985
Deposit insurance premiums		958		1,080
Professional fees		231		561
Printing and supplies expense		81		134
Dues and subscriptions		96		93
Postage		82		54
Foreclosed real estate		772		361
Loss on sale of repossessed assets		2		9
Debt extinguishment expense		-		66
Loan legal		245		151
Loan appraisal		144		43
Other loan related expense		983		12
Corporate insurance		107		46
Other		424		579
Total	$	10,819	$	11,055

During the first six months of 2011, the Company recorded income tax benefit of $287,000 based on a pre-tax book loss of $193,000. For the six months of 2010, the Company recorded income tax expense of $319,000 based on pre-tax income of $1.0 million.

Liquidity

A function of the Company’s Asset-Liability Management Committee is evaluating the current liquidity of the Bank and identifying and planning for future liquidity needs. Such needs primarily consist of ensuring sufficient liquidity to meet current or expected needs for deposit withdrawals and the funding of investing activities, principally the making of loans and purchasing of securities. Liquidity is provided by cash flows from maturing investments, loan payments and maturities, federal funds sold, and unpledged investment securities. On the liability side of the balance sheet, liquidity sources include core deposits, the ability to increase large denomination certificates of deposit and borrowings from the Federal Home Loan Bank (FHLB), as well as the ability to generate funds through the issuance of long-term debt and equity. The Bank’s “on balance sheet” liquidity ratio was 29% at June 30, 2011. Management considers this ratio to be more than adequate to meet known or anticipated liquidity needs. The Company, however, has limited sources of revenue, and the Written Agreement and the Consent Order do not permit the payment of dividends by the Bank to the Company. Without this primary source of revenue from the Bank, the Company expects to continue to defer the payment of dividends on its Preferred Stock.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

Total deposits were $677.0 million at June 30, 2011, up slightly from $674.3 million at December 31, 2010. Deposit growth and retention within the Bank’s retail branch bank network was sufficient to meet the Company’s funding requirements during 2010 and through the first half of 2011. In prior years, the Bank used brokered deposits as a supplemental liquidity source. The Consent Order prohibits the Bank from soliciting and accepting additional brokered CDs (including the renewal of existing brokered CDs) without prior approval from the FDIC and limits the rates the Bank can offer on its deposit products. At June 30, 2011, brokered deposits totaled $35.6 million, compared to $42.4 million at December 31, 2010. The majority of the Bank’s brokered deposits mature in 2011, and it is expected sufficient funds will be available from cash on hand, investment security repayments, and loan repayments to fund the Bank’s obligations. At June 30, 2011, time deposits represented 53.8% of the Bank’s total deposits, compared to 56.6% at December 31, 2010. Certificates of deposit of $100,000 or more represented 24.6% of the Bank’s total deposits at June 30, 2011, down from 26.9% at year-end 2010. Management believes a sizeable portion of the Bank’s time deposits are relationship-oriented, and based upon prior experience, anticipates a substantial portion of outstanding certificates of deposit will renew upon maturity. Deposit retention is also influenced by limits on the rates the Bank can offer.

Wholesale borrowings, an additional source of liquidity for the Bank, totaled $4.8 million and $8.3 million at June 30, 2011 and December 31, 2010, respectively, and were comprised solely of advances from the FHLB. Management expects to continue to use wholesale borrowings and potentially other wholesale sources of funding, as allowed under the Consent Order, to supplement deposits generated from the Bank’s branch network and assist in managing the overall cost of funds. As of June 30, 2011, loan collateral has been pledged to the FHLB to borrow an additional $12.9 million. Secured borrowings lines with two financial institutions totaling $12.0 million are also available to meet liquidity needs.

Capital Resources

At June 30, 2011, the Company’s equity totaled $38.5 million, compared to $37.3 million at December 31, 2010. The $1.1 million increase in equity is primarily attributable to an increase in the unrealized gains on the investment securities portfolio. The Company’s equity-to-asset ratio on those dates was 5.3% and 5.2%, respectively. The Company is subject to minimum capital requirements, which are further discussed in “PART 1, ITEM 1 - Business — Supervision and Regulation” of the Company’s Annual Report.

All capital ratios categorize the Company as “adequately capitalized” by regulatory measures at June 30, 2011. The Company’s regulatory capital ratios as of that date consisted of a leverage ratio of 4.51%, a Tier I risk-based capital ratio of 7.00%, and a total risk-based capital ratio of 8.26%. At December 31, 2010, these ratios were 4.30%, 6.76% and 8.04%, respectively. Pursuant to the Consent Order and Written Agreement, the Bank is required to develop and adopt a plan for achieving and maintaining capital ratios in excess of the minimum thresholds for the Bank to be well-capitalized, specifically Tier 1 capital of at least 8% of total assets and a total risk based capital ratio of at least 12%. We continue to consider plans to secure an equity infusion. Given the state of equity markets currently, our ability to raise capital in the foreseeable future is unknown. If additional equity cannot be secured, or can only be secured at an unexpectedly high cost, this could adversely affect the Company and the Bank.

Note 17 to the accompanying consolidated financial statements presents an analysis of the Company’s and Bank’s regulatory capital position as of June 30, 2011 and December 31, 2010.

Asset/Liability Management

Market risk refers to the risk of loss arising from adverse changes in interest rates, foreign exchange rates, commodity prices, and other relevant market rates and prices such as equity prices. Due to the nature of our operations, we are primarily exposed to interest rate risk and liquidity risk.

Interest rate risk within our consolidated balance sheets consists of reprice, option, and basis risks. Reprice risk results from differences in the maturity, or repricing, of asset and liability portfolios. Option risk arises from “embedded options” present in many financial instruments, such as loan prepayment options, deposit early withdrawal options, and interest rate options. These options allow customers opportunities to benefit when market interest rates change, which typically results in higher expense or lower income for us. Basis risk refers to the potential for changes in the underlying relationship between market rates and indices, which subsequently result in a narrowing of the profit spread on an interest-earning asset or interest-bearing liability. Basis risk is also present in administered rate liabilities, such as savings accounts, negotiable order of withdrawal accounts, and money market accounts with respect to which historical pricing relationships to market rates may change due to the level or directional change in market interest rates.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

We seek to avoid fluctuations in our net interest margin and to maximize net interest income within acceptable levels of risk through periods of changing interest rates. Accordingly, our Asset / Liability Committee (ALCO) and the Board of Directors monitor our interest rate sensitivity and liquidity on an ongoing basis. The Board of Directors and ALCO oversee market risk management and establish risk measures, limits, and policy guidelines for managing the amount of interest rate risk and its impact on net interest income and capital. ALCO uses a variety of measures to gain a comprehensive view of the magnitude of interest rate risk, the distribution of risk, the level of risk over time, and the exposure to changes in certain interest rate relationships.

We use a simulation model as the primary quantitative tool in measuring the amount of interest rate risk associated with changing market rates. The model measures the impact on net interest income relative to a base case scenario of hypothetical fluctuations in interest rates over the upcoming 12 and 24-month periods. These simulations incorporate assumptions regarding balance sheet growth and mix, pricing, and the repricing and maturity characteristics of the existing and projected consolidated balance sheets. Other interest rate related risks, such as prepayment, basis, and option risk, are also considered in the model.

ALCO continuously monitors and manages the volume of interest sensitive assets and interest sensitive liabilities. Interest-sensitive assets and liabilities are those that reprice or mature within a given timeframe. The objective is to manage the impact of fluctuating market rates on net interest income within acceptable levels. In order to meet this objective and mitigate potential market risk, management develops and implements investment, lending, funding and pricing strategies.

The following table summarizes the forecasted impact on net interest income using a base case scenario given upward and downward movements in interest rates of 200, 300, and 400 basis points based on forecasted assumptions of prepayment speeds, nominal interest rates and loan and deposit repricing rates as of June 30, 2011. Estimates are based on current economic conditions, historical interest rate cycles and other factors deemed to be relevant. However, underlying assumptions may be impacted in future periods which were not known to management at the time of the issuance of the consolidated financial statements. Therefore, management’s assumptions may or may not prove valid. No assurance can be given that changing economic conditions and other relevant factors impacting our net interest income will not cause actual occurrences to differ from underlying assumptions. Although measured, we believe the downward movements included below are neither realistic nor anticipated in the current historically low interest rate environment.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011


	Percentage Change in Net Interest Income from Base
	Immediate Shock						Gradual Ramp
Interest Rate Scenario (1)	12 Months			24 Months			12 Months			24 Months
	Column 1			Column 2			Column 3			Column 4
Up 400 basis points		27.4	%		7.7	%		5.4	%		0.3	%
Up 300 basis points		21.4	%		6.7	%		4.1	%		0.5	%
Up 200 basis points		14.7	%		5.1	%		3.1	%		0.9	%
Base		-			-			-			-
Down 200 basis points		-14.4	%		-15.0	%		-8.5	%		-11.3	%
Down 300 basis points		-38.5	%		-44.2	%		-9.2	%		-15.2	%
Down 400 basis points		-39.0	%		-45.2	%		-12.2	%		-20.7	%

(1)

The rising and falling interest rate scenarios in the first two columns assume an immediate and parallel change in interest rates along the entire yield curve. The gradual ramp scenarios presented in the third and fourth columns assume a gradual rise or fall in interest rates during the periods indicated.

There is material limitations with the model presented above, which include, but are not limited to:

●

It presents the balance sheet in a static position. When assets and liabilities mature or reprice, they do not necessarily keep the same characteristics.

●

The computation of prospective impacts of hypothetical interest rate changes are based on numerous assumptions and should not be relied upon as indicative of actual results.

●

The computations do not contemplate any additional actions we could undertake in response to changes in interest rates.

1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2011

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not Applicable

ITEM 4. CONTROLS AND PROCEDURES

The Company’s management, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the design and operation of our disclosure controls and procedures in accordance with Rule 13a-15 of the Securities Exchange Act of 1934 (the “Exchange Act”). Based on the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, our disclosure controls and procedures were effective in enabling us to provide reasonable assurance that we were able to record, process, summarize and report in a timely manner the information required to be disclosed in periodic reports we file under the Exchange Act.

No change in our internal control over financial reporting was identified that occurred during the Company’s second fiscal quarter of 2011 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

None

ITEM 1A. RISK FACTORS

Not Applicable

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None

ITEM 4. (REMOVED AND RESERVED)

ITEM 5. OTHER INFORMATION

Not Applicable

ITEM 6. EXHIBITS

Exhibit Number		Description

31.01		Rule 13a-14(a)/15(d)-14(a) Certification by Michael G. Mayer

31.02		Rule 13a-14(a)/15(d)-14(a) Certification by Holly L. Schreiber

32.01		Rule 1350 Certifications

SIGNATURES

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

	1st Financial Services Corporation (Registrant)

Date: August 11, 2011	By:	/s/ Michael G. Mayer
		Michael G. Mayer
		Chief Executive Officer


Date: August 11, 2011		/s/ Holly L. Schreiber
		Holly L. Schreiber
		Chief Financial Officer

EXHIBIT INDEX


Exhibit Number		Description

31.01		Rule 13a-14(a)/15(d)-14(a) Certification by Michael G. Mayer

31.02		Rule 13a-14(a)/15(d)-14(a) Certification by Holly L. Schreiber

32.01		Rule 1350 Certifications

Attached files

Stock widget

Investing forum

1st Financial Services CORP Reports