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Article by DailyStocks_admin    (01-23-09 10:51 AM)

Filed with the SEC from Jan 08 to Jan 14:

First Security Group (FSGI)
Sandler O'Neill Asset Management raised its stake to 1,100,600 shares (6.7%) from the 900,000 (5.48%) that it had reported owning on Oct. 16, 2008.

BUSINESS OVERVIEW

Unless otherwise indicated, all references to “First Security,” “we,” “us,” and “our” in this Annual Report on Form 10-K refer to First Security Group, Inc. and our wholly-owned subsidiary, FSGBank, National Association (FSGBank).

BUSINESS

First Security Group, Inc.

We are a bank holding company headquartered in Chattanooga, Tennessee. We currently operate 39 full service banking offices and five loan and lease production offices through our wholly-owned bank subsidiary, FSGBank. We serve the banking and financial needs of various communities in eastern and middle Tennessee and northern Georgia.

Through FSGBank, we offer a range of lending services which are primarily secured by single and multi-family real estate, residential construction and owner-occupied commercial buildings. In addition, we make loans to small and medium-sized businesses, as well as to consumers for a variety of purposes. Our principal source of funds for loans and investing in securities is core deposits. We offer a wide range of deposit services, including checking, savings, money market accounts and certificates of deposit. We obtain most of our deposits from individuals and businesses in our market areas. We actively pursue business relationships by utilizing the business contacts of our Board of Directors, senior management and local bankers, thereby capitalizing on our knowledge of the local marketplace.

First Security Group, Inc. was incorporated in 1999 as a Tennessee corporation to serve as a bank holding company, and is regulated and supervised by the Board of Governors of the Federal Reserve System (Federal Reserve Board). As of December 31, 2007, we had total assets of approximately $1.2 billion, total deposits of approximately $902.6 million and shareholders’ equity of approximately $147.7 million.

FSGBank, National Association

FSGBank currently operates 39 full-service banking-offices and five loan and lease production offices along the Interstate corridors of eastern and middle Tennessee and northern Georgia, and is primarily regulated by the Office of the Comptroller of the Currency (OCC). In Dalton, Georgia, FSGBank operates under the name of Dalton Whitfield Bank, while FSGBank operates under the name of Jackson Bank & Trust along the Interstate 40 corridor. FSGBank also provides trust and investment management, mortgage banking, financial planning and electronic banking services, such as Internet banking (www.FSGBank.com), online bill payment, cash management, ACH originations, and remote deposit capture, as well as equipment leasing through its wholly owned subsidiaries, Kenesaw Leasing and J&S Leasing. FSGBank operates a full-service banking office in Dalton, Georgia under the name Primer Banco Seguro, which is an initiative marketed toward and serving Northwest Georgia’s Latino population.

FSGBank is the successor to our three previous banks: Dalton Whitfield Bank (organized in 1999), Frontier Bank (acquired in 2000) and First State Bank (acquired in 2002). From December 31, 2002 to December 31, 2007, our business model has produced strong results through a combination of internal growth and acquisitions. Specifically, we have:


• increased our total consolidated assets from $472.9 million to $1.2 billion;

•increased our total consolidated deposits from $384.5 million to $902.6 million;


•increased our total consolidated loans from $348.6 million to $953.1 million;

• expanded our branch network from 16 branches to 40 branches; and


• successfully integrated all of our banking subsidiaries into a single national bank.

Dalton Whitfield Bank was a state bank organized under the laws of Georgia engaged in a general commercial banking business. Dalton Whitfield Bank opened for business in September 1999, and simultaneously acquired selected assets and substantially all of the deposits of Colonial Bank’s three branches located in Dalton, Georgia. In 2003, Premier National Bank of Dalton merged with and into Dalton Whitfield Bank for an aggregate purchase price of $11.7 million in cash and stock.

Frontier Bank was a state savings bank organized under the laws of Tennessee in 2000 as First Central Bank of Monroe County. We acquired First Central Bank of Monroe County in 2000 for an aggregate purchase price of $2.3 million in cash. After the acquisition, First Central Bank of Monroe County was renamed Frontier Bank and re-chartered as a state bank under the laws of Tennessee to engage in a general commercial banking business. Outside of the Chattanooga market, Frontier Bank operated under the name of “First Security Bank.”

First State Bank was a state bank organized under the laws of Tennessee engaged in a general commercial banking business since its organization in 1974. We acquired First State Bank in 2002 for an aggregate purchase price of $8.6 million in cash.

During 2003, we converted each of our three subsidiary banks into national banks, renamed each bank “FSGBank, National Association” and merged the banks under the charter previously held by Frontier Bank. As a result, we consolidated our banking operations into one subsidiary, FSGBank. FSGBank currently conducts its banking operations in Dalton, Georgia under the names “Dalton Whitfield Bank” and “Primer Banco Seguro.” Primer Banco Seguro is our Latino-focused banking initiative.

Since the mergers in 2003, FSGBank has continued the commercial banking business of its predecessors. In addition, in December of 2003, FSGBank acquired certain assets and assumed substantially all of the deposits and other liabilities of National Bank of Commerce’s three branch offices located in Madisonville, Sweetwater and Tellico Plains, Tennessee.

In October 2004, FSGBank acquired 100% of the capital stock of Kenesaw Leasing and J&S Leasing, both Tennessee corporations, from National Bank of Commerce for $13.0 million in cash. Both companies continue to operate as wholly-owned subsidiaries of FSGBank. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery primarily to companies in the trucking and construction industries.

In August 2005, we acquired Jackson Bank & Trust (Jackson Bank) for an aggregate purchase price of $33.3 million in cash. Jackson Bank was a state commercial bank headquartered in Gainesboro, Tennessee. Jackson Bank was merged into FSGBank, but we continue to operate our banking operations in Jackson and Putnam Counties, Tennessee under the name of “Jackson Bank & Trust.”

FSGBank is a member of the Federal Reserve Bank of Atlanta and a member of the Federal Home Loan Bank of Cincinnati (FHLB). FSGBank’s deposits are insured by the FDIC. FSGBank operates 31 full-service banking offices in eastern and middle Tennessee and eight offices in northern Georgia. Additionally, FSGBank operates four loan and lease production offices in Tennessee, and one loan production office in Georgia.

Business Strategy

We target both consumers and small to medium-sized businesses in our markets and have developed a decentralized strategy that focuses on providing superior customer service through our employees who are relationship-oriented and committed to their respective communities. Through this strategy we intend to grow our business, expand our customer base and improve profitability. The key elements of our strategy are:

Grow Along Interstate Corridors in Eastern and Middle Tennessee and Northern Georgia. We seek to increase our presence in our primary markets along the Interstate 75 and 40 corridors as well as to extend into other interstate corridors in eastern and middle Tennessee and northern Georgia through selective acquisitions and the opening of new branches in attractive locations. In 2005, the acquisition of Jackson Bank extended our franchise along Interstate 40 toward Nashville. In 2007 and 2006, we opened two de novo branches in Cleveland, Tennessee, as well as a de novo branch in Algood, Tennessee, near Cookeville, and one in Varnell, Georgia. In 2008, we expect to continue to leverage our existing bank branches, possibly open a de novo branch and actively pursue strategic acquisitions.

These interstate communities are primarily served by branches of large regional and national financial institutions headquartered outside of the area. As a result, we believe these markets need, and are best served by, a locally owned and operated financial institution managed by people in and from the communities served. As we grow, we believe it is important to maintain the local flexibility created by local banks with smart bankers while benefiting from the economies of scale created by our size.

We intend to continue our growth strategy through organic growth and strategic acquisitions. We believe that many opportunities remain in our market area to expand, and we intend to be in a position to acquire additional market share, whether via acquisitions or de novo branches with the right local management. We will continue to identify targets that assist us in achieving strategic and/or financial targets, with the goal of being the bank that other banks call when they have decided to pursue an exit strategy. Although the interstate corridors are our primary focus, we may consider acquiring banking operations outside of the corridors if attractive opportunities arise as we continuously evaluate acquisition opportunities.

Maintain Local Decision Making and Accountability. We effectively compete with our super-regional competitors by providing superior customer service with localized decision-making capabilities. We designate regional bank presidents and separate advisory boards in each of our markets so that we are positioned to react quickly to changes in those communities while maintaining efficient and consistent centralized reporting and policies.

We offer personalized and flexible banking services to the communities in our market area and are able to react quickly to changes in those communities, in part by maintaining local advisory boards. Instead of setting standardized rates across the organization, we continue to give our local markets control over their respective rates. While emphasizing standards to encourage efficiency, control is decentralized to permit rapid adjustments to community changes. We also offer products tailored to the specific needs of our communities.

We are in the process of standardizing the consumer loan approval and pricing process to reduce our risks and costs on consumer loans. We believe this change will provide consistency in our pricing and risks throughout our markets.

Provide a Diversified Revenue Stream. We seek to provide an array of financial products and services to meet the needs of our customers and to increase our fee income. In order to diversify our loan portfolio and to help better serve the needs of our business customers, we offer leasing services through our two leasing companies, Kenesaw Leasing and J&S Leasing. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery primarily to companies in the trucking and construction industries. Our wealth management division offers private client services, financial planning, trust administration, investment management and estate planning services.

Our loan portfolio mix reflects our market opportunities, and presents a strong mix of loans. As of December 31, 2007, our largest category of loans, 1-4 family residential, represented only 27.5% of our loan Index to Financial Statements

portfolio. Commercial real estate represented 23.0%, of which 59% were owner-occupied, while construction and development loans represented 22.7% of the loan portfolio. The balance of the portfolio consists of commercial and industrial loans, consumer loans, commercial leases and multi-family loans. Our construction and development loan portfolio is similarly diverse, evenly divided between commercial construction, residential construction and residential acquisition and development, and with our top ten relationships only representing 27% of our construction and development loan commitments.

Maintain Our Asset Quality. We consider asset quality to be of primary importance and have taken measures to ensure that despite growth in our loan portfolio we consistently maintain strong asset quality. Over the past few years, we have improved our commercial underwriting standards, developed a detailed loan policy, established better warning and early detection procedures, strengthened our commercial real estate management practices, improved consumer portfolio risk based pricing and standardized underwriting, and developed a more comprehensive analysis of our allowance for loan losses. Our loan review process targets 60% to 70% of our portfolio for review over an eighteen month cycle. More frequent loan reviews may be completed as needed or as directed by the Audit/Corporate Governance Committee of the Board of Directors.

We believe the effect of these activities is reflected in nearly all of our asset quality measures compared to our peer group, as defined by the Uniform Bank Performance Report as of December 31, 2007. At December 31, 2007, our net charge-offs as a percentage of average loans decreased 16 basis points from 0.28% to 0.12%. The ratio of nonaccrual loans plus loans 90 days past due to gross loans was 0.59% and 1.06% for us and our peer group, respectively. The ratio of nonaccrual loans and loans 90 days past due to the allowance for loan losses was 51.67% and 90.17% for us and our peer group, respectively. At December 31, 2007, the reserves as a percentage of total loans was 1.15% and 1.19% for us and our peer group, respectively.

Improve Core Profitability. We believe we will be able to take advantage of the economies of scale typically enjoyed by larger organizations as we grow our franchise. We believe the investments we have made in our key employees and our branch network are sufficient to support a much larger organization, and therefore the increases in our expense base going forward should be lower than our proportional increase in assets and revenues. Furthermore, we have the capability to increase our assets without breaching our capital ratio requirements and we are also targeting an improved efficiency ratio. We believe the effect of these trends going forward should improve our profitability over time.

Our net income for the year ended December 31, 2007 was approximately $11.4 million compared to $11.1 million for 2006, which represents an increase of 2.22%. For 2007 our annualized return on average equity was 7.75% and our annualized return on average assets was 0.99%, compared to 7.91% and 1.03% for 2006, respectively. Our Tier 1 capital to risk adjusted assets, total capital to risk adjusted assets and leverage ratio were 10.8%, 11.8% and 9.7%, respectively as of December 31, 2007 compared to 12.0%, 13.1% and 10.5%, respectively as of December 31, 2006. Our capital ratios exceed the minimum capital ratios for well capitalized institutions for each respective period. Our core efficiency ratio for 2007 improved to 64.05%, compared to 64.27% for 2006.

Index to Financial Statements

Market Area and Competition

We currently conduct business principally through 39 branches in our market areas of Bradley, Hamilton, Jackson, Jefferson, Knox, Loudon, McMinn, Monroe, Putnam and Union Counties, Tennessee and Catoosa and Whitfield Counties, Georgia. Our markets follow the Interstate 75 corridor between Dalton, Georgia (one hour north of Atlanta, Georgia) and Jefferson City, Tennessee (30 minutes north of Knoxville, Tennessee) and the Interstate 40 corridor between Nashville, Tennessee and Knoxville, Tennessee. Based upon data available on the FDIC website as of June 30, 2007, FSGBank’s total deposits ranked 6 th among financial institutions in our market area, representing approximately 4.5% of the total deposits in our market area. The table below shows our deposit market share in the counties we serve according to data from the FDIC website as of June 30, 2007.

On March 6, 2008, we closed one branch in Whitfield County.

Our retail, commercial and mortgage divisions operate in highly competitive markets. We compete directly in retail and commercial banking markets with other commercial banks, savings and loan associations, credit unions, mortgage brokers and mortgage companies, mutual funds, securities brokers, consumer finance companies, other lenders and insurance companies, locally, regionally and nationally. Many of our competitors compete with offerings by mail, telephone, computer and/or the Internet. Interest rates, both on loans and deposits, and prices of services are significant competitive factors among financial institutions generally. Office locations, types and quality of services and products, office hours, customer service, a local presence, community reputation and continuity of personnel are also important competitive factors that we emphasize.

In addition, our leasing operations via Kenesaw Leasing and J&S Leasing primarily serve lease customers located within 150 miles of Knoxville, Memphis and Nashville, Tennessee.

Many other commercial or savings institutions currently have offices in our primary market areas. These institutions include many of the largest banks operating in Tennessee and Georgia, including some of the largest banks in the country. Many of our competitors serve the same counties we do. Within our market area, there are 62 different commercial or savings institutions.

Virtually every type of competitor for business of the type served by our bank has offices in Atlanta, Georgia, approximately 75 miles from Dalton and 100 miles from Chattanooga. In our market area, our largest competitors include First Tennessee, Regions, SunTrust, BB&T and Wachovia. These institutions, as well as Index to Financial Statements

other competitors of ours, have greater resources, have broader geographic markets, have higher lending limits, offer various services that we do not offer and can better afford and make broader use of media advertising, support services and electronic technology than we do. To offset these competitive disadvantages, we depend on our reputation as being an independent and locally-owned community bank and as having greater personal service, community involvement and ability to make credit and other business decisions quickly and locally.

Lending Activities

We originate loans primarily secured by single and multi-family real estate, residential construction and owner-occupied commercial buildings. In addition, we make loans to small and medium-sized commercial businesses, as well as to consumers for a variety of purposes.

Commercial — Leases . Our commercial lease portfolio includes leases made by our leasing companies, Kenesaw Leasing and J&S Leasing. Kenesaw Leasing leases new and used equipment, fixtures and furnishings to owner-managed businesses, while J&S Leasing leases forklifts, heavy equipment and other machinery to owner-managed businesses primarily in the trucking and construction industries. The leased property usually serves as collateral for the lease. Our commercial leases are underwritten on the basis of the value of the underlying leased property as well as the basis of the commercial lessee’s ability to service the lease. Commercial leases generally entail greater risks than commercial loans or loans secured by real estate, but less risk than unsecured consumer loans. The increased risk in commercial leases is generally due to the rolling stock nature of the items leased, as well as the illiquid nature of the secondary market for used equipment. The increased risk also derives from the low barriers to entry in the trucking and construction industries.

Commercial — Loans. Our commercial loan portfolio includes loans to smaller business ventures, credit lines for working capital and short-term seasonal or inventory financing, as well as letters of credit that are generally secured by collateral other than real estate. Commercial borrowers typically secure their loans with assets of the business, personal guaranties of their principals and often mortgages on the principals’ personal residences. Our commercial loans are primarily made within our market areas and are underwritten on the basis of the commercial borrower’s ability to service the debt from income. In general, commercial loans involve more credit risk than residential and commercial mortgage loans, but less risk than consumer loans. The increased risk in commercial loans is generally due to the type of assets collateralizing these loans. The increased risk also derives from the expectation that commercial loans generally will be serviced from the operations of the business, and those operations may not be successful.

Consumer. We make a variety of loans to individuals for personal, family and household purposes, including secured and unsecured installment and term loans. Consumer loans entail greater risk than other loans, particularly in the case of consumer loans that are unsecured or secured by depreciating assets such as automobiles. In these cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan balance. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be affected by job loss, divorce, illness or personal hardships.

Real Estate — Construction. We also make construction and development loans to residential and, to a lesser extent, commercial contractors and developers located within our market areas. Construction loans generally are secured by first liens on real estate and have floating interest rates. Construction loans involve additional risks attributable to the fact that loan funds are advanced upon the security of a project under construction, and the value of the project is dependent on its successful completion. As a result of these uncertainties, construction lending often involves the disbursement of substantial funds with repayment dependent, in part, upon the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If we are forced to foreclose on a project prior to completion, there is no assurance that we will be able to recover all of the unpaid portion of the loan. In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period of time. While we have underwriting procedures designed to identify what we believe to be acceptable levels of risks in construction lending, no assurance can be given that these procedures will prevent losses from the risks described above.

Real Estate — Mortgage. We make commercial mortgage loans to finance the purchase of real property as well as loans to smaller business ventures, credit lines for working capital and short-term seasonal or inventory financing, including letters of credit, that are also secured by real estate. Commercial mortgage lending typically involves higher loan principal amounts, and the repayment of loans is dependent, in large part, on sufficient income from the properties collateralizing the loans to cover operating expenses and debt service. As a general practice, we require our commercial mortgage loans to be collateralized by well-managed income producing property with adequate margins and to be guaranteed by responsible parties. In addition, a substantial percentage of our commercial mortgage loan portfolio is secured by owner-occupied commercial buildings. We look for opportunities where cash flow from the collateral provides adequate debt service coverage and the guarantor’s net worth is centered on assets other than the project we are financing. Our commercial mortgage loans are generally collateralized by first liens on real estate, have fixed or floating interest rates and amortize over a 10 to 20-year period with balloon payments due at the end of one to five years. Payments on loans collateralized by such properties are often dependent on the successful operation or management of the properties. Accordingly, repayment of these loans may be subject to adverse conditions in the real estate market.

In underwriting commercial mortgage loans, we seek to minimize our risks in a variety of ways, including giving careful consideration to the property’s operating history, future operating projections, current and projected occupancy, location and physical condition. Our underwriting analysis also includes credit checks, reviews of appraisals and environmental hazards or EPA reports and a review of the financial condition of the borrower. We attempt to limit our risk by analyzing our borrowers’ cash flow and collateral value on an ongoing basis.

CEO BACKGROUND
The Board has approved, subject to receiving shareholder approval, an amendment to First Security’s Articles of Incorporation to authorize a class of 10,000,000 shares of Preferred Stock, no par value (the “Preferred Stock”). A copy of the amendment is set forth in Appendix A to this Proxy Statement. The Articles of Incorporation currently authorize only shares of common stock. The amendment will vest in the Board the authority to determine by resolution the terms of one or more series of Preferred Stock, including the preferences, rights, and limitations of each series.

Provisions in a company’s articles of incorporation authorizing Preferred Stock in this manner are often referred to as “blank check” provisions because they give a board of directors the flexibility, at any time or from time to time, without further shareholder approval (except as may be required by applicable laws, regulatory authorities, or the rules of any stock exchange on which the company’s securities are then listed), to create one or more series of Preferred Stock and to determine by resolution the terms of each such series. The authority of the board of directors with respect to each series, without limitation, includes a determination of the following: (a) the number of shares to constitute the series, (b) the liquidation rights, if any, (c) the dividend rights and rates, if any, (d) the rights and terms of redemption, (e) the voting rights, if any, which may be full, special, conditional, or limited, (f) whether the shares will be convertible or exchangeable into securities of the company, and the rates thereof, if any, (g) any limitations on the payment of dividends on the common stock while any series is outstanding, (h) any other provisions that are not inconsistent with the articles of incorporation, and (i) any other preference, limitations, or rights that are permitted by law.

The Board believes that authorization of the Preferred Stock in the manner proposed is in the best interests of First Security and its shareholders. Authorization of the Preferred Stock will provide First Security with greater flexibility in meeting future capital requirements by creating series of Preferred Stock customized to meet the needs of particular transactions and then prevailing market conditions. Series of Preferred Stock would also be available for issuance from time to time for any other proper corporate purposes, including in connection with strategic alliances, joint ventures, or acquisitions.

The Board believes that the flexibility to issue Preferred Stock can enhance the Board’s arm’s-length bargaining capability on behalf of First Security’s shareholders in a takeover situation. However, under some circumstances, the ability to designate the rights of, and issue, Preferred Stock could be used by the Board to make a change in control of First Security more difficult. See “Anti-Takeover Provisions of the Articles of Incorporation and Bylaws.”

The rights of the holders of First Security’s common stock will be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. To the extent that dividends will be payable on any issued shares of Preferred Stock, the result would be to reduce the amount otherwise available for payment of dividends on outstanding shares of common stock and there might be restrictions placed on First Security’s ability to declare dividends on the common stock or to repurchase shares of common stock. The issuance of Preferred Stock having voting rights would dilute the voting power of the holders of common stock.

To the extent that Preferred Stock is made convertible into shares of common stock, the effect, upon such conversion, would also be to dilute the voting power and ownership percentage of the holders of common stock. In addition, holders of Preferred Stock would normally receive superior rights in the event of any dissolution, liquidation, or winding-up of First Security, thereby diminishing the rights of the holders of common stock to distribution of First Security’s assets. To the extent that Preferred Stock is granted preemptive rights, it would entitle the holder to a preemptive right to purchase or subscribe for additional shares of First Security.

The Board does not have any plans calling for the issuance of shares of Preferred Stock at the present time, other than the possible issuance of Preferred Stock to the U.S. Department of the Treasury (the “Treasury”) in
connection with the Treasury’s recently announced Troubled Asset Relief Program (“TARP”) Capital Purchase Program described below. Regardless of whether First Security ultimately issues Preferred Stock under the TARP Capital Purchase Program, the Board believes that approval of the proposed amendment to the Articles of Incorporation is in First Security’s best interests for the reasons described above.

The TARP Capital Purchase Program

On October 14, 2008, the U.S. Department of the Treasury announced the TARP Capital Purchase Program. This program was instituted by the Treasury pursuant to the Emergency Economic Stabilization Act of 2008 (“EESA”), which provides up to $700 billion to the Treasury to, among other things, take equity positions in financial institutions. The TARP Capital Purchase program is intended to encourage U.S. financial institutions to build capital and thereby increase the flow of financing to businesses and consumers.

Under the TARP Capital Purchase program, the Treasury will purchase senior preferred shares of senior Preferred Stock from banks, bank holding companies, and other financial institutions. The senior preferred shares will qualify as Tier 1 capital for regulatory purposes and will rank senior to the common stock. The senior preferred shares purchased by the Treasury will pay a cumulative dividend rate of 5% per annum for the first five years they are outstanding and thereafter at a rate of 9% per annum. The senior preferred shares will be non-voting but will have voting rights on matters that could adversely affect the shares. After three years, the shares will be callable at 100% of the issue price plus any accrued and unpaid dividends. Prior to the end of three years, the senior preferred shares may be redeemed with the proceeds from a qualifying equity offering of any Tier 1 perpetual preferred or common stock. The Treasury’s consent will be required for any increase in common dividends per share or certain repurchases of common stock until the third anniversary of the date of this investment unless prior to such third anniversary either the Preferred Stock issued to the Treasury is redeemed in whole or the Treasury has transferred all of the Preferred Stock to third parties.

If First Security participates in the TARP Capital Purchase Program, then we must issue to the Treasury warrants to purchase common stock with an aggregate market price equal to 15% of the senior Preferred Stock purchased by the Treasury. The exercise price of the warrants will be the market price of our common stock at the time of preliminary approval, calculated on a 20-trading day trailing average. If we sell the maximum amount of Preferred Stock authorized under the TARP Capital Purchase Program, then we estimate that warrants to purchase approximately 700 thousand shares of common stock would be issued. The amount of dilution will depend on the actual amount of capital received, the average price of our stock for the 20-day period prior to receiving approval, and the value of our stock upon the exercise of the warrants.

Also, if First Security participates in the Program, then we must adopt the Treasury’s standards for executive compensation and corporate governance set forth in Section 111 of EESA for the period during which the Treasury holds equity issued under this Program. To ensure compliance with these standards, within the time frame prescribed by the Treasury for the Capital Purchase Program, we plan to enter into agreements with its senior executive officers who would be subject to the standards. The executive officers would agree to, among other things, (1) “clawback” provisions relating to the repayment by the executive officers of incentive compensation based on materially inaccurate financial statements or performance metrics and (2) limitations on certain post-termination “parachute” payments. We anticipate that our senior executive officers will execute the agreements in the event that our participation in the Capital Purchase Program is approved.

See Appendix B for the Summary of Senior Preferred Terms and Summary of Warrant Terms as published by the Treasury.

First Security filed an application on November 10, 2008 in the TARP Capital Purchase Program seeking a $33.0 million investment. The minimum subscription amount available to a participating institution is 1% of risk-weighted assets. The maximum subscription amount is the lesser of $25 billion or 3% of risk-weighted assets. For First Security, the minimum amount would be approximately $11.2 million and the maximum amount would be approximately $33.4 million. If the Treasury were to deny our application or reduce the amount of capital available to us under the Capital Purchase Program, management does not believe that our liquidity, capital resources, or results of operations would be materially affected.

Pro Forma Financial Information

The unaudited pro forma condensed consolidated financial data set forth below has been derived by the application of pro forma adjustments to First Security’s historical financial statements for the year ended December 31, 2007 and the nine months ended September 30, 2008. The unaudited pro forma consolidated financial data gives effect to the events discussed below as if they had occurred on January 1, 2007 in the case of the statement of income data and September 30, 2008 in the case of the balance sheet and regulatory capital ratio data. The key assumptions in the following pro forma statements include the following:


•The issuance of Preferred Stock under Treasury’s Capital Purchase Program for $11.2 million and $33.4 million for the minimum and maximum investment, respectively, as defined by the Program,


•The issuances of warrants to purchase approximately 232,000 and 696,000 shares of First Security common stock, respectively, for the minimum and maximum investment under the Capital Purchase Program, and


•The investment of the proceeds in earning assets.

First Security presents unaudited pro forma consolidated balance sheet data, including selected line items from our balance sheet and selected capital ratios, as of September 30, 2008. We also present unaudited pro forma condensed consolidated income statements for the year ended December 31, 2007 and the nine months ended September 30, 2008. The pro forma financial data may change materially based on the timing and utilization of the proceeds as well as certain other factors including the strike price of the warrants, any subsequent changes in First Security’s common stock price, and the discount rate used to determine the fair value of the Preferred Stock.

The information should be read in conjunction with First Security’s audited financial statements and the related notes as filed as part of our Annual Report on Form 10-K for the year ended December 31, 2007, and our unaudited consolidated financial statements and the related notes filed as part of our Quarterly Report on Form 10-Q for the quarter ended September 30, 2008.

The following unaudited pro forma consolidated financial data is not necessarily indicative of our financial position or results of operations that actually would have been attained had proceeds from the Capital Purchase Program been received, or the issuance of the warrants pursuant to the Capital Purchase Program been made, at the dates indicated, and is not necessarily indicative of our financial position or results of operations that will be achieved in the future. In addition, as noted above, our participation in the Capital Purchase Program is subject to our shareholders approving the proposed amendment to our Articles of Incorporation described in this Proxy Statement.

We have included the following unaudited pro forma consolidated financial data solely for the purpose of providing shareholders with information that may be useful for purposes of considering and evaluating the proposal to amend our Articles of Incorporation. Our future results are subject to prevailing economic and industry specific conditions and financial, business and other known and unknown risks and uncertainties, certain of which are beyond our control. These factors include, without limitation, those described in this Proxy Statement and those described under Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2007, in Item 1A of our Quarterly Report on Form 10-Q for the quarter ended September 30, 2008 and in our other reports filed with the SEC.

(1) Assumes the Capital Purchase Program proceeds are invested in earning assets (consisting of agency guaranteed securities). The actual impact to net interest income would be different as First Security expects to utilize a portion of the proceeds to fund future prudent loan growth. However, such impact cannot be estimated at this time as the impact of the investments would vary in timing and pricing.
(2) Consists of the minimum and maximum Preferred Stock issuance under the Treasury’s Capital Purchase Program. The value of the Preferred Stock and associated warrants are allocated based on the relative fair value of the warrants as compared to the fair value of the Preferred Stock. The Preferred Stock is valued using a discounted cash flow model. The warrants are valued under the Black-Scholes pricing model.
(3) As described in Section titled “The TARP Capital Purchase Program,” the value of the warrants uses the following assumptions under the Black-Scholes pricing model: the First Security common stock price, dividend yield, stock price volatility, and the risk-free interest rate. The common stock price is based on a 20-day trading day trailing average as of November 17, 2008.
(4) The discount on the Preferred Stock is amortized over a 5-year period via the effective yield method.

(1) Assumes the Capital Purchase Program proceeds are invested in earning assets (consisting of agency guaranteed securities with an assumed effective yield of 5.04%). The actual impact to net interest income would be different as First Security expects to utilize a portion of the proceeds to fund future prudent loan growth. However, such impact cannot be estimated at this time as the impact of the investments would vary in timing and pricing.
(2) Additional income tax expense is attributable to additional net interest income as described in Note 1 at the statutory rate of 35%.
(3) Consists of dividends of $558 thousand and $1.7 million for the minimum and maximum investments, respectively, on Preferred Stock at a 5% annual rate as well as $152 thousand and $455 thousand for the minimum and maximum investments, respectively, of accretion on discount on Preferred Stock upon issuance. The discount is determined based on the value that is allocated to the warrants upon issuance. The discount is accreted back to par value on an effective yield method over a 5-year term, which is the expected life of the Preferred Stock upon issuance. The estimated accretion is based on a number of assumptions that are subject to change. These assumptions include the discount (market rate at issuance) rate on the Preferred Stock, and assumptions underlying the value of the warrants. The proceeds are allocated based on the relative fair value of the warrants as compared to the fair value of the Preferred Stock. The fair value of the warrants is determined under a Black-Scholes model. The model includes assumptions regarding First Security’s common stock price, dividend yield, stock price volatility, as well as assumptions regarding the risk-free interest rate. The lower the value of the warrants, the less negative impact on net income and earnings per share available to common shareholders. The fair value of the Preferred Stock is determined based on assumptions regarding the discount rate (market rate) of Preferred Stock (currently estimated at 14%). The lower the discount rate, the less negative impact on net income and earnings per share available to common shareholders.

(4) As described in the Section titled “The TARP Capital Purchase Program,” the Treasury would receive warrants to purchase a number of shares of our common stock having an aggregate market price equal to 15% of the proceeds on the date of issuance with a strike price equal to the trailing 20-day trading average leading up to the closing date. This pro forma assumes that the warrants would give the Treasury the option to purchase 232,000 and 696,000 shares of First Security common stock, respectively, for the minimum and maximum investment under the Capital Purchase Program. The pro forma adjustment shows the increase in diluted shares outstanding assuming that the warrants had been issued on January 1, 2007 at a strike price of $7.21 (based on First Security’s trailing 20-day average share price as of November 17, 2008) and remained outstanding for the entire period presented. The treasury stock method was utilized to determine dilution of the warrants for the period presented.

MANAGEMENT DISCUSSION FROM LATEST 10K

The following discussion and analysis should be read in conjunction with “Selected Financial Data” and our consolidated financial statements and notes included in this Annual Report on Form 10-K. The discussion in this Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, such as our plans, objectives, expectations, and intentions. The cautionary statements made in this Annual Report on Form 10-K should be read as applying to all related forward-looking statements wherever they appear in this Annual Report. Our actual results could differ materially from those discussed in this Annual Report on Form 10-K.

Year Ended December 31, 2007

The following discussion and analysis sets forth the major factors that affected First Security’s financial condition as of December 31, 2007 and 2006, and results of operations for the three years ended December 31, 2007 as reflected in the audited financial statements.

Overview

As of December 31, 2007, we had total consolidated assets of approximately $1.2 billion, total loans of approximately $953.1 million, total deposits of approximately $902.6 million and stockholders’ equity of approximately $147.7 million. In 2007, our net income was $11.4 million, resulting in basic and diluted net income of $0.67 and $0.66 per share, respectively.

As of December 31, 2006, we had total consolidated assets of approximately $1.1 billion, total loans of approximately $847.6 million, total deposits of approximately $922.0 million and stockholders’ equity of approximately $144.8 million. In 2006, our net income was $11.1 million, resulting in basic and diluted net income of $0.64 and $0.63 per share, respectively.

Net interest income and non-interest income for 2007 increased by $940 thousand and $683 thousand respectively, while non-interest expense, including provision for loan losses, increased by $1.4 million as compared to 2006. Excluding the other-than-temporary impairment in 2007 and the available-for-sale securities losses in 2007 and 2006, non-interest income increased $1.2 million. Income increases outpaced expense increases as a result of the change in the mix of earning assets towards loans, as well as the growing diversified stream of non-interest income from trust services, fees on deposit accounts and mortgage banking activity. The increase in expenses is mainly due to higher salaries and benefits associated with the average full-time equivalent employees increasing by twelve to 372 for 2007 due to opening two new branches and a loan production office.

We maintained our efficiency ratio in 2007 relative to 2006 at 68.8% versus 68.3%, which reflects a sustained improvement from 71.8% in 2005. Excluding the securities impairment charge and losses on sales of securities, we have improved our efficiency ratio each year: 68.0% in 2007, 68.1% in 2006 and 71.6% in 2005. The efficiency ratio for 2007 was impacted by the opening of our new corporate headquarters in December 2006, the opening of de novo branches in Cleveland and Cookeville, Tennessee in April and May 2007, respectively, as well as a loan production office in Marietta, Georgia in April 2007. We expect to continue achieving further efficiencies by growing our operating revenue faster than our expenses. In the future, we plan to identify additional locations in Knoxville, Chattanooga, and Cleveland, Tennessee, as well as locations for expansion into the north metro Atlanta, Georgia and metro Nashville, Tennessee markets. At this time, we have a written option to purchase land for a future de novo branch in Hixson (Chattanooga), Tennessee. While we will be opportunistic, we are mindful of the additional expense associated with de novo branches.

Net interest margin in 2007 was 4.79% or 30 basis points lower as compared to the prior period of 5.09%. The net interest margin of our peer group (as reported on the December 31, 2007 Uniform Bank Performance Report) was 3.95% and 4.12% for 2007 and 2006, respectively. As expected, our margin declined due to the higher cost of deposits associated with a greater reliance on certificates of deposits and other borrowings.

Index to Financial Statements

Additionally, the easing of the target federal funds target rate by the Federal Reserve Board reduced our yield on earning assets during the third and fourth quarters of 2007. Through January 30, 2008, the Federal Reserve Board has reduced the target federal funds target rate by 225 basis points in a five month period. Further rate cuts are currently expected in 2008. We anticipate our margin to decrease between 20 and 30 basis points in the first quarter of 2008 from the 4.61% margin for the fourth quarter of 2007. The margin for the remainder of 2008 will be dependant on our ability to raise core deposits, our growth rate in loans, and any possible further actions by the Federal Reserve Board.

Critical Accounting Policies

Our accounting and reporting policies are in accordance with accounting principles generally accepted in the United States of America and conform to general practices within the banking industry. Critical accounting policies include the initial adoption of an accounting policy that has a material impact on our financial presentation as well as accounting estimates reflected in our financial statements that require us to make estimates and assumptions about matters that were highly uncertain at the time. Disclosure about critical estimates is required if different estimates that we reasonably could have used in the current period would have a material impact on the presentation of our financial condition, changes in financial condition or results of operations. Accounting policies related to the allowance for loan losses and the impairment of goodwill and other intangible assets each represent a critical accounting estimate.

The allowance for loan and lease losses is established and maintained at levels management deems adequate to absorb credit losses inherent in the portfolio as of the balance sheet date. The level is based on past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect a borrower’s ability to repay, underlying estimated values of collateral securing loans, current economic conditions and other factors. Should any of these factors change, the estimate of credit losses in the loan portfolio and the related allowance would also change. Refer to the “Provision for Loan and Lease Losses” section for a discussion of our methodology of establishing the allowance for loan and lease losses.

We periodically review the carrying values of intangible assets not subject to amortization, including goodwill, to determine whether an impairment exists. Statement of Financial Standards No. 142, Goodwill and Other Intangible Assets, prescribes the accounting for goodwill and intangible assets subsequent to initial recognition. These assets are subject to at least an annual impairment review and more frequently if certain impairment indicators are in evidence. Changes in the estimates and assumptions used to evaluate impairment may have a material impact on the Company’s consolidated financial statements, results of operations or liquidity.

Results of Operations

We reported net income for 2007 of $11.4 million versus net income for 2006 of $11.1 million and net income for 2005 of $9.6 million after the recognition of extraordinary gain of $2.2 million. In 2007, basic net income per share was $0.67 on approximately 17.0 million shares and diluted net income per share was $0.66 on approximately 17.3 million weighted average shares outstanding. In 2006, basic net income per share was $0.64 on approximately 17.3 million shares and diluted net income per share was $0.63 on approximately 17.7 million weighted average shares outstanding. In 2005, basic net income per share was $0.65 on approximately 14.6 million shares and diluted net income per share was $0.64 on approximately 14.9 million weighted average shares outstanding.

Net income in 2007 was above the 2006 level as a result of our organic loan growth and growing fee income, partially offset by a decreasing net interest margin. Our overhead also increased in 2007 because of our new corporate headquarters, which opened in December 2006 and our two new de novo branches, which opened in April and May 2007, and additional full-time equivalent employees. As of December 31, 2007, we had 40 banking offices, including the headquarters, five leasing offices and 371 full time equivalent employees.

Index to Financial Statements

Although we expect to continue to expand our branch network and our employee force in 2008, we are mindful of the fact that growth and increasing the number of branches adds expenses (such as administrative costs and occupancy, salaries and benefits expenses) before earnings.

Further explanation, with year-to-year comparisons of the income and expense, is provided below.

Net Interest Income

Net interest income (the difference between the interest earned on assets, such as loans and investment securities, and the interest paid on liabilities, such as deposits and other borrowings) is our primary source of operating income. In 2007, net interest income was $48.9 million or 2% more than the 2006 level of $48.0 million, which in turn was 19% more than the 2005 level of $40.4 million.

The level of net interest income is determined primarily by the average balances (volume) of interest earning assets and the various rate spreads between our interest earning assets and our funding sources. Changes in net interest income from period to period result from increases or decreases in the volume of interest earning assets and interest bearing liabilities, increases or decreases in the average interest rates earned and paid on such assets and liabilities, the ability to manage the interest earning asset portfolio (which includes loans), and the availability of particular sources of funds, such as noninterest bearing deposits.

Interest income in 2007 was $83.5 million, an 11% increase over the 2006 level of $75.1 million, which was a 33% increase over the 2005 level of $56.3 million. Year-to-year increases since 2005 are due to the annual increases in the volume of earning assets and a shift in the earning asset mix from investment securities and federal funds sold to our higher yielding loan portfolio. Average loans in 2007 were $904.5 million, an increase of $107.6 million or 14% over 2006. All other earning assets were $136.6 million, a decrease of $27.5 million or 17%. Total average earning assets in 2007 were $1.0 billion, an increase of $80.1 million or 8% from 2006 average earning assets. We decreased our securities portfolio by electing to shift a portion of the recurring cash flow from interest, principal paydowns and maturities, as well as transferring the proceeds from securities sales, into the loan portfolio. Our increase in loans year-over-year in 2007 was made feasible by the deposit gathering activities at FSGBank, the use of alternative funding through overnight advances from the Federal Home Loan Bank (FHLB) and the shifting mix of earning assets. These additional earning assets in 2007 have enabled us to earn more interest income.

Supplementing the additional earnings from increased volumes was the increases in yield on earning assets. The tax equivalent yield on earning assets increased 19 basis points in 2007 to 8.11% from 7.92% in 2006, which was 78 basis points higher than 2005. The changes in the yield rates for 2007 relate to (1) our changing the mix of earning assets, (2) the fourth quarter 2006 sale of approximately $9.8 million of investment securities with an average yield of 3.65% and (3) the second quarter 2007 sale of approximately $27.0 million of securities with an average yield of approximately 4.32%. The proceeds from the 2007 sale of the securities were used to de-leverage a portion of our balance sheet by reducing our overnight borrowings, which eliminated negative spread. The changes in the yield rates for 2006 relate to our changing the mix of earning assets towards loans and the Federal Reserve Board increases in the target federal funds rate.

Total interest expense was $34.6 million in 2007 compared to $27.1 million in 2006 and to $15.9 million in 2005. The increase in interest expense in 2007 is primarily due to rising interest rates caused by competitive pressures and the Federal Reserve Board’s increases to the target federal funds rate in 2006, combined with the additional volume of interest bearing liabilities. Deposit pricing, especially CDs, typically lags changes in the target federal funds rate, and therefore we did not see an immediate impact to the lowering of rates by the Federal Reserve Board in the fourth quarter of 2007. Due to those rate cuts, as well as further cuts in the first quarter of 2008, we expect our interest rate expense, assuming a stable volume of interest bearing liabilities, to decline in 2008. The increase in interest expense in 2006 was primarily due to raising interest rates on deposits and the additional volume of interest bearing liabilities, which included the impact of Jackson Bank for the full year. The average rate paid on average interest bearing liabilities increased 60 basis points to 4.15% for 2007 from 3.55% in 2006 and increased 103 basis points from 2.52% in 2005. Our rate increases in 2007 are a reflection of the market conditions and a greater reliance on higher cost non-core funding. Average interest bearing liabilities increased $69.2 million or 9% in 2007 compared to 2006 and $136.0 million or 22% in 2006 compared to 2005. The increase in 2007 is primarily due to increases in in-market certificates of deposits and the use of other borrowings, including FHLB overnight borrowings. The significant increase in interest bearing liabilities in 2006 was due to our market penetration and the full year of Jackson Bank. Average total deposits grew $37.3 million or 4% to $924.6 million in 2007 and increased $152.5 million or 21% to $887.3 million in 2006. We feel that our average rate paid on interest bearing liabilities will decrease in the first half of the 2008 as our time deposits mature and reprice at current market rates, which have decreased since the Federal Reserve Board’s rate decrease initiative started in September of 2007. However, competitive pressures and our potential inability to raise core deposits, which could result in an increased use of higher cost alternative funding, may partially offset the impact of the rate cuts.

The banking industry uses two key ratios to measure the relative profitability of net interest income: net interest rate spread and net interest margin. The net interest rate spread measures the difference between the average yield on earning assets and the average rate paid on interest bearing liabilities. The net interest rate spread does not consider the impact of noninterest bearing deposits and gives a direct perspective on the effect of market interest rate movements. The net interest margin is defined as net interest income as a percentage of total average earning assets and takes into account the positive effects of investing noninterest bearing deposits in earning assets.

First Security’s net interest rate spread (on a tax equivalent basis) was 3.96% in 2007, 4.37% in 2006 and 4.62% in 2005, while the net interest margin (on a tax equivalent basis) was 4.79% in 2007, 5.09% in 2006 and 5.15% in 2005. The decrease in the net interest spread and net interest margin for 2007 was primarily due to our rates on interest bearing liabilities rising faster than the yields on earning assets. The decrease in the net interest spread and net interest margin for 2006 was primarily due to (1) the Jackson Bank acquisition, (2) the rates on interest bearing deposits increasing at a faster pace than the yields on earning assets due to the competition for deposits in our markets, (3) the flat to inverted yield curve interest rate environment and (4) the lag in CD repricing. Average interest bearing liabilities as a percentage of average earning assets was 80% in 2007, 80% in 2006 and 79% in 2005.

In late June 2007, we entered into a series of cash flow swaps with a total notional value of $150 million. Floating rate cash flow payments on a portion of our Prime-based variable rate loans were swapped for fixed rate payments. We entered the swaps to mitigate our interest rate risk in a falling interest rate environment. The market volatility and the increasing anticipation of interest rate easing by the Federal Reserve created an unrealized gain of over $2.0 million. On August 28, 2007, we unwound the swaps and locked in a gain of approximately $2.0 million. The gain is being accreted into interest income over the expected term of the variable rate loans hedged. For 2008, the gain translates into 40 basis points of income on $150 million notional value. The accretion of $205 thousand for 2007 was included in interest income. In October 2007, we entered into a total of $50 million notional value cash flow swaps. The swaps exchanged a portion of or Prime-based variable rate payments for fixed rate payments. The fixed rate is appropriately 7.72% and the term is five years.

Through January 30, 2008, the Federal Reserve Board has reduced the target federal funds rate by 225 basis points in a five month period. Further rate cuts are currently expected in 2008. We anticipate our margin to decrease between 20 and 30 basis points in the first quarter of 2008 from the 4.61% margin for the fourth quarter of 2007. The margin for the remainder of 2008 will depend on our ability to raise core deposits, the growth rate in loans, and any possible further rate cuts by the Federal Reserve Board .

In 2005, the Federal Reserve Board raised the target federal funds rate eight times by a total of 200 basis points to 4.25%. In 2006, the Federal Reserve Board raised the target federal funds rate four times by a total of 100 basis points to 5.25%. In 2007, the Federal Reserve Board reduced the target federal funds rate three times by a total of 100 basis points to 4.25%. During the first month of 2008, the Federal Reserve Board lowered the target federal funds rate twice by a total of 125 basis points to 3.00%.

MANAGEMENT DISCUSSION FOR LATEST QUARTER

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

Certain of the statements made under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere throughout this Form 10-Q are forward-looking statements for purposes of the Securities Act of 1933 and the Securities Exchange Act of 1934. Forward-looking statements relate to future events or our future financial performance and may involve known or unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of First Security to be materially different from future results, performance, or achievements expressed or implied by such forward-looking statements. Forward-looking statements include statements using the words such as “may,” “will,” “anticipate,” “should,” “would,” “believe,” “contemplate,” “expect,” “estimate,” “continue,” “intend,” “seeks,” or other similar words and expressions of the future.

These forward-looking statements involve risks and uncertainties, and may not be realized due to a variety of factors, including, without limitation: the effects of future economic conditions, governmental monetary and fiscal policies, as well as legislative and regulatory changes; the risks of changes in interest rates on the level and composition of deposits, loan demand, and the values of loan collateral, securities, and interest sensitive assets and liabilities; the costs of evaluating possible acquisitions and the risks inherent in integrating acquisitions; the effects of competition from other commercial banks, thrifts, mortgage banking firms, consumer finance companies, credit unions, securities brokerage firms, insurance companies, money market and other mutual funds and other financial institutions operating in First Security’s market area and elsewhere, including institutions operating regionally, nationally and internationally, together with such competitors offering banking products and services by mail, telephone, computer and the Internet; and, the failure of assumptions underlying the establishment of reserves for possible loan losses. All written or oral forward-looking statements attributable to First Security are expressly qualified in their entirety by this Special Note.

THIRD QUARTER 2008 AND RECENT EVENTS

The following discussion and analysis sets forth the major factors that affected results of operations and financial condition reflected in the unaudited financial statements for the three and nine month periods ended September 30, 2008 and 2007. Such discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and the notes attached thereto.

Recent Regulatory Events

In response to the financial crisis affecting the banking system and financial markets, on October 3, 2008, the Emergency Economic Stabilization Act of 2008 (the “EESA”) was signed into law. Pursuant to the EESA, the U.S. Treasury will have the authority to, among other things, purchase up to $700 billion of mortgages, mortgage-backed securities and certain other financial instruments from financial institutions for the purpose of stabilizing and providing liquidity to the U.S. financial markets.

On October 14, 2008, Secretary Paulson announced that the Department of the Treasury will purchase equity stakes in a wide variety of banks and thrifts. Under this program, known as the Troubled Asset Relief Program Capital Purchase Program (the “TARP Capital Purchase Program”), from the $700 billion authorized by the EESA, the Treasury will make $250 billion of capital available to U.S. financial institutions in the form of preferred stock. In conjunction with the purchase of preferred stock, the Treasury will receive warrants to purchase common stock with an aggregate market price equal to 15% of the preferred investment. Participating financial institutions will be required to adopt the Treasury’s standards for executive compensation and corporate governance for the period during which the Treasury holds equity issued under the TARP Capital Purchase Program. The Treasury has announced that publicly traded institutions that wish to participate in the TARP Capital Purchase Program must apply before 5:00 pm (EST) on November 14, 2008. Institutions that receive Treasury approval to participate in the TARP Capital Purchase Program have 30 days to satisfy all requirements for participation and to complete the issuance of the senior preferred shares to the Treasury.


Eligible financial institutions can generally apply to issue senior preferred shares to the Treasury in aggregate amounts between 1% to 3% of the institution’s risk-weighted assets. This would permit us to apply for an investment by the Treasury of between approximately $11 million and $33 million. We are evaluating whether to apply for participation in the TARP Capital Purchase Program.

Also on October 14, 2008, after receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Paulson signed the systemic risk exception to the FDIC Act, enabling the FDIC to temporarily provide a 100% guarantee of the unsecured senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing transaction deposit accounts under a Temporary Liquidity Guarantee Program. Coverage under the Temporary Liquidity Guarantee Program is available for 30 days without charge and thereafter at a cost of 75 basis points per annum for senior unsecured debt and 10 basis points per annum for non-interest bearing transaction deposits. All institutions are covered automatically under the Temporary Liquidity Guarantee Program until the opt out deadline of December 5, 2008. We currently intend to remain in the program.

OVERVIEW

As of September 30, 2008, we had total consolidated assets of $1.3 billion, total loans of $1.0 billion, total deposits of $976.5 million and stockholders’ equity of $148.5 million.

Net income for the three months ended September 30, 2008, was $826 thousand, or $0.05 per share (basic and diluted), compared to net income of $3.0 million, or $0.18 per share (basic and diluted) for the comparative period in 2007. Net income for the nine months ended September 30, 2008, was $4.7 million, or $0.29 per share (basic and diluted), compared to net income of $8.3 million, or $0.48 and $0.47 per basic and diluted share, respectively, for the comparative period of 2007.

For the three and nine month periods ending September 30, 2008, net interest income decreased by $830 thousand and $2.0 million, respectively, while noninterest income decreased by $37 thousand and increased by $1.0 million, respectively, compared to the same period in 2007. For the three and nine months ended September 30, 2008, non-interest expense decreased by $851 thousand and $935 thousand, respectively, compared to the same period in 2007. The provision for loan and lease losses increased $3.4 million and $5.7 million for the three and nine months ended September 30, 2008, respectively, compared to the same period in 2007. The decline in net interest income is primarily a result of the rate cuts by the Federal Reserve Board that have occurred over the last twelve months. Noninterest income on a year-to-date basis continues to increase through a growing diversified stream of revenue, including trust department income, fees on deposit accounts and mortgage banking activity. Consistent with our approach to control expenses, noninterest expense decreased on a year-to-date basis through reductions in salaries and benefits, furniture and equipment expenses and professional fees. Full-time equivalent employees were 365 at September 30, 2008 compared to 373 in 2007.

Our efficiency ratio improved in the third quarter of 2008 to 65.8% compared to 67.6% in the same period of 2007. The decrease relates to the decline in non-interest expense offsetting the percentage declines in net interest income and noninterest income. We seek further efficiencies by growing our operating revenue faster than our expenses, although declining net interest income may lead to a higher efficiency ratio in the near term. In April and May 2007, we opened de novo branches in Algood, Tennessee and Cleveland, Tennessee, respectively. We anticipate opening a branch in Hixson, Tennessee in early 2009. We are continuing to pursue opportunities for additional locations in Chattanooga, Knoxville, and Cleveland, Tennessee. While we will be opportunistic, we are mindful of the additional expense associated with the de novo growth model.

Net interest margin in the third quarter of 2008 was 4.13% or 67 basis points lower compared to the prior year period of 4.80% and 1 basis point higher than the 4.12% net interest margin for the second quarter of 2008. We believe that our net interest margin will decline in the fourth quarter of 2008 before stabilizing again in early 2009 due to the 100 basis point decrease in the target federal funds rate during October as well as our liquidity enhancement strategy to replace overnight borrowings with longer term funding sources such as issuing brokered deposits. The projected stabilization of our net interest margin in early 2009 is dependent on competitive pricing pressure and our ability to raise core deposits as well as our projection of a stable target federal funds rate. However, any further decrease to the target federal funds rate by the Federal Reserve Board may cause additional margin compression.

On July 15, 2008, the Volkswagen Group of America, Inc. announced plans to build a $1 billion automobile production facility in Chattanooga, Tennessee. The plant will bring about 2,000 direct jobs, including approximately 400 white-collar jobs, and up to 12,000 indirect jobs to the region. We believe the positive economic impact on Chattanooga and the surrounding region will be significant. We believe the plant will stabilize and possibly increase real estate values, as well as provide increased overall economic activity in the region.

On October 22, 2008, our Board of Directors approved a fourth quarter cash dividend of $0.05 per share payable on December 16, 2008 to shareholders of record on December 1, 2008.

On November 6, 2008, our Board of Directors approved an amendment to our Articles of Incorporation authorizing up to 10,000,000 shares of blank check preferred stock. The amendment is subject to shareholder approval.

RESULTS OF OPERATIONS

We reported net income for the three and nine month periods ended September 30, 2008 of $826 thousand and $4.7 million, respectively, versus net income for the same periods in 2007 of $3.0 million and $8.3 million, respectively. In the third quarter of 2008, basic and diluted net income per share was $0.05 on approximately 16.1 million basic and 16.2 million diluted weighted average shares outstanding, respectively. On a year-to-date basis, basic and diluted net income per share was $0.29 on approximately 16.1 million shares and 16.2 million weighted average shares outstanding, respectively.

Net income on a quarterly and year-to-date basis in 2008 was below the comparable amounts in 2007 as a result of the contraction in the net interest margin and higher provision for loan and lease loss expense. While our total assets have increased, our overhead decreased for the year-to-date period in 2008 compared to 2007, through a reduction in salaries and benefits, furniture and equipment expenses as well as lower intangible asset amortization. As of September 30, 2008, we had 39 banking offices, including the headquarters, four loan/lease production offices and 365 full-time equivalent employees. Although we are planning on expanding our branch network and our employee force, we are mindful of the fact that growth and increasing the number of branches adds expenses (such as administrative costs, occupancy, and salaries and benefits expenses) before earnings.

The following table summarizes the components of income and expense and the changes in those components for the three and nine month periods ended September 30, 2008 compared to the same period in 2007.

CONF CALL
Rodger Holley

Good afternoon, everyone. Thank you for joining us. Today, we announced our financial results for the third quarter. And I would like to highlight some of the results.

Net income of $826,000, diluted earnings per share of $5 billion. Total assets of $1.282 billion at quarter-end. Total loans $1.17 billion, a modest increase of $10.8 million from the second quarter 2008. Total deposits $976.5 million at quarter-end compared to $950.5 million at the end of the second quarter 2008.

Net charge-offs for the quarter were $2.5 million, 0.98% on a quarterly annualized basis. And the allowance for loan and lease losses was increased to 1.31%, from 1.18% at the end of the second quarter. For the third quarter provision expense was $3.96 million compared to $1.95 million in the second quarter, and $1.18 million of the first quarter. Given the additional credit costs that we and many others in the industry are facing we are pleased with this quarter's results.

I would like to spend a few minutes on the subject of asset quality and then allow Dave Haynes to elaborate further.

In response to the downturn of the national economy, and some slowing locally, the frequency of our credit monitoring have increased. We are taking a proactive aggressive step and managing through credit issues when they arise.

Our third quarter charge-off rate was decidedly larger than we had planned. One relationship accounted for nearly three quarters of the total for this quarter. We had maintained a longstanding relationship with this account. However, the borrowers business saw a quick and pronounced downturn and was unable to refinance and/or sell several real estate related projects due in part to the overall tightening of the credit market. We maintain a relationship with this account and we are aggressively pursuing collection of the charge-off.

Regarding our regional economy, as you may know, we are headquartered in Chattanooga, Tennessee and operating communities along I-75 corridor between Dalton, Georgia, Nashville, Tennessee and along asset I-40 corridor based in Nashville, Tennessee, and this region we did face many of the same economic issues that are affecting most of the U.S. such as slower housing sales, higher gas and diesel prices, and inflationary pressure. However, we are fortunate in that this area has and continues to see positive growth trend.

Without the highs and lows of some market, as you might recall from last quarter's call Volkswagen Group of America announced on July 15 it would build the U.S. automotive production facility on the 1350 acre mega site 12 miles Northeast of Downtown, Chattanooga, and adjacent I-75. This manufacturing plant will bring about 2,000 direct jobs and up to 10,000 related jobs to the area. Hiring has begun and site work is well underway on the new facility which is scheduled to begin production in year 2011.

Because of this economic development in our core regions, we feel the impact of the economic downturn will not be as severe regionally as in other areas. Our analysis of our asset quality indicates that we are running about 90 days behind other areas. And with this economic development we feel we may come out of the downturn ahead of other wages. However, we won't be realistic about our economy.

Our customers are conscious, they are tightening their belts and demonstrating a wait and see attitude. This attitude is reflected in our loan and lease pipeline. Presently, our pipeline is running about half of previous quarter end level or about $45 million.

The loans and leases making up this total are evenly split over all major loan categories. We too are conscious, and we too are tightening our belts. Also, we feel this pipeline is very reflective of our aggressive stands on lending an asset quality. We are not spreading to grow loans, and we have been careful with the type, term and structure of the loans and leases that we did make.

I will now turn it over to Dave Haynes who will discuss the bank asset quality in some detail.

Dave Haynes

Net charge-offs for the third quarter were $2.5 million or 0.98% on a quarterly annualized basis as compared with the second quarter net charge-offs of $1.405 million. The annualized year-to-date net charge-offs through September 30th is 0.63%. As Rodger mentioned, one borrower accounted for 74% of net charge-offs for this quarter.

Total non-performing assets were $15.6 million at the end of the third quarter, up $2.6 million from the linked quarter. The majority of the increase was caused by the addition of $2.5 million and remaining loans placed on non-accrual and not charged off from the one borrower previously mentioned. Non-accrual loans and leases totaled 8.773 million at quarter-end, an increase of 1.928 million from the linked quarter.

Other real estate owned was $5.561 million at the end of the third quarter, up $956,000 from the linked quarter while we possess assets were $1.293 million, down $246,000 from the second quarter.

The classified loans and leases increased by $18.226 million from the second quarter and totaled $54.824 million at quarter-end. Provision for [ph] loans and leases are 50% of Tier 1 capital and 5.4% of total loans and leases. The special mention risk rate grade category has increased to $21.9 million, primarily as a result of CRE, C&D loan downgrade. The special mention loans and leases represent over 2% of total loans and leases.

In the third quarter we provided an additional $3.96 million for loan losses, $1.95 million over the linked quarter and $3.4 million over the prior year quarter. The increase provision was necessary due to the increased stress that is in place on our borrowers. This provision increases our allowance to 1.31% of total loans at quarter-end. The allowance for loan and lease losses to non-performing assets stands at 85.33% at the end of the third quarter. The allowance for loan and lease losses to non-accrual loans is 152% at September 30, 2008.

Total CRE and C&D loans net of owner occupied loans was $275 million as of September 30th which represents a slight increase from $271 million reported from the linked quarter. These groups of loans are 224% of risk-based capital. C&D loans continue to decline and are presently $165 million which is a 135% of risk-based capital as compared to 143% from the linked quarter. We are continuing our effort to identify problem loans early and to seek problem loans strategy to minimize losses.

I will now turn it over to Chip Lusk to discuss our financial performance for the quarter.

Chip Lusk

Thanks, Dave. My comments will touch on the income statement and the net interest margin, but we will focus on our liquidity and capital positions. On a quarter over linked quarter basis our net interest spread improved by $280,000 as our end market CDAR continue to reprice down at a faster pace than our earning asset.

Cost of funding and market retail CD decreased 33 basis points and the cost of funding end market jumbo CD decreased 32 basis points. Overall, our cost of funding decreased 19 basis points to 3.08% whereas our yield on earning assets was down 14 basis points to 6.67%. Our net interest margin expanded by 1 basis point in the third quarter. We do expected to come under pressure again from the Fed's recent 50 basis point rate cut as well as from our plans to enhance our liquidity. Speaking of which we target and maintain our liquidity ratio of 12% non-pledged liquid assets to end market deposit and short-term LIBOR. Short-term meaning one year less.

In addition, we maintain sufficient unused contingent funding sources to adequately meet our short-term needs in the event of a severe credit and liquidity crisis. Looking back to the latter half of 2007 and the first half of 2008 we allowed our overnight borrowing position to increase over $100 million in order to arrive the yield curve down and offset some of our asset sensitivity. Our overnight borrowings are based on Federal funds rate not on LIBOR.

In light of some recent large bank failures we decided to enhance our liquidity, our reducing our exposure to overnight funding and target a cash neutral funding position. Liquidity enhancement and protection strategy we have evaluated over the past six months and adopted over the past few months include Number one, brokered money market which are priced to target fed funds rate plus 50 basis points. Number two, we are cyclical in one way buy CDARS or Certificate of Deposit Account Registry Service through Promontory Interfinancial network and number three, the reserve cash management suite to replace our collateralized commercial repurchase agreement. Paying off our overnight borrowings with these strategy and traditional brokerage CDs will negatively affect our margins, but it will provide us with stability and strength until the national credit and liquidity crisis subside.

As for our contingent funding sources, include $137.3 million of collateralized borrowing capacity, FHLD [ph], $69.2 million of potential repurchase agreement using currently unpledged investment securities. $78 million of unsecured Federal fund lines of credit and the Federal Reserve's discount window to which we have not yet applied but plans to do so as an abundance of caution.

Now, I want to circle back to our liquid assets. Our investment portfolio was $134 million at quarter-end and performing well. We did not hold any Fannie Mae or Freddie Mac common or preferred stock or sub-debt. But we did hold $14 million of AAA Senior unsecured debt which we sold one week prior to the treasury taking the agencies into conservatorship.

We sold the bonds due to the uncertainty of the treasury's role and their lack of communication regarding their willingness to assume the agencies obligation. As a result of the transaction we booked $146,000 pretax gain on the sale which we believed a non-interest income.

Comparing a third quarter with the linked second quarter noninterest income increased by $61,000 or 2%. Excluding the gain on sale of investments non-interest income was down $85,000 or 2.8% due primarily to $78,000 decline in mortgage origination income.

As for noninterest expense, we cut our expenses by $558,000 or 5.4% on a quarter-over-linked quarter basis. On a year-to-date – year-over-year basis total noninterest expenses are down $935,000 or 3% while at the same time FDIC insurance premiums are up $318,000 or 224% due to the higher deposit insurance premium imposed on the industry.

Based on our calculation of a new and recently released FDIC insurance rate, including the 10 basis points for non-interest bearing DDAs our premiums will increase by approximately $810,000 in 2009.

Turning now to shareholders equity. For the 12th consecutive quarter, we paid our cash dividend. This was our 8th consecutive quarter at 5/10th per share. At quarter-end, our shares outstanding were unchanged from the linked quarter-end. However, our ESOP purchased 71,000 shares during the quarter which along with the lower stock price increased our weighted average diluted shares outstanding of $78,000.

Over the next several weeks, we will continue to evaluate the benefits and costs of the one-time opportunity to participate in the TARP capital purchase program regardless of our decision we take some comfort in our tangible equity ratio which remains solid at 9.5%.

I will turn it back to Rodger.

Rodger Holley

In closing, I would like to review some of our fundamentals. We are $1.3 billion bank with 39 locations, operating east Tennessee, northern Georgia. Our NPAs to total assets 1.22%. Our allowance for loan and lease losses now stands at 1.31% of loans. We have a firm hand on our operating expenses and as others are we are tightening our belts.

We paid a cash dividend for 12 consecutive quarters. We remain profitable. Until recently, capital was king [ph], and we are well capitalized at 9.5% to tangible capital ratio.

Now, liquidity is king. Chip and his staff done a great job of structuring our balance sheet so we can call in liquidity on short notes. This is critical. We have the ability to borrow over $200 million in collateralized assets.

Finally, that single large charge-off this quarter cost us $0.07 per share. And the additional $5.7 million in provision expense in 2008, above the 2007 provision expense cost us $0.23 per share. Fundamentally, we remain sound. Fundamentally, strong, and position to win. We are now available for questions.

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