FSGI-2013.9.30-10Q

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

_________________________________________________

FORM 10-Q

_________________________________________________

(Mark One)



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

For the quarterly period ended September 30, 2013



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

For the transition period from to .

COMMISSION FILE NO. 000-49747

_________________________________________________

FIRST SECURITY GROUP, INC.

(Exact Name of Registrant as Specified in its Charter)

_________________________________________________



Tennessee	58-2461486
(State of Incorporation)	(I.R.S. Employer Identification No.)

531 Broad Street, Chattanooga, TN	37402
(Address of principal executive offices)	(Zip Code)



	(423) 266-2000
	(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 or 15(d) of the Securities and Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No ¨

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

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨	Smaller reporting company	ý

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: Common Stock, $0.01 par value: 66,602,601 shares outstanding and issued as of November 13, 2013

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First Security Group, Inc. and Subsidiary

Form 10-Q

INDEX



		Page No.
PART I.	FINANCIAL INFORMATION	1

Item 1.	Financial Statements (Unaudited)	1

	Consolidated Balance Sheets - September 30, 2013, December 31, 2012 and September 30, 2012	1

	Consolidated Statements of Operations - Three and nine months ended September 30, 2013 and 2012	3

	Consolidated Statements of Comprehensive Loss - Three and nine months ended September 30, 2013 and 2012	4

	Consolidated Statement of Shareholders’ Equity - Nine months ended September 30, 2013	5

	Consolidated Statements of Cash Flows - Nine months ended September 30, 2013 and 2012	6

	Notes to Consolidated Financial Statements	8

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	51

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	88

Item 4.	Controls and Procedures	89

PART II.	OTHER INFORMATION	90

Item 1.	Legal Proceedings	90

Item 1A.	Risk Factors	90

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	90

Item 3.	Defaults Upon Senior Securities	90

Item 4.	Mine Safety Disclosures	90

Item 5.	Other Information	90

Item 6.	Exhibits	91

SIGNATURES		92

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PART I - FINANCIAL INFORMATION


ITEM 1.	FINANCIAL STATEMENTS (UNAUDITED)

First Security Group, Inc. and Subsidiary

Consolidated Balance Sheets



	September 30, 2013		December 31, 2012		September 30, 2012
(in thousands)	(unaudited)		December 31, 2012		(unaudited)
ASSETS
Cash and Due from Banks	$	10,357	$	12,806	$	10,204
Interest Bearing Deposits in Banks	59,943		159,665		201,631
Cash and Cash Equivalents	70,300		172,471		211,835
Securities Available-for-Sale	207,009		254,057		257,263
Securities Held-to-Maturity, at amortized cost (fair value - $130,170)	129,164		—		—
Loans Held for Sale	1,661		25,920		3,857
Loans	534,627		541,130		573,365
Less: Allowance for Loan and Lease Losses	10,700		13,800		17,490
Net Loans	523,927		527,330		555,875
Premises and Equipment, net	28,810		29,304		29,540
Bank Owned Life Insurance	28,155		27,576		27,364
Intangible Assets, net	388		600		677
Other Real Estate Owned	8,662		13,441		15,803
Other Assets	13,779		12,856		15,256
TOTAL ASSETS	$	1,011,855	$	1,063,555	$	1,117,470

(See Accompanying Notes to Consolidated Financial Statements)

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First Security Group, Inc. and Subsidiary

Consolidated Balance Sheets



	September 30, 2013			December 31, 2012			September 30, 2012
(in thousands, except share and per share data)	(unaudited)						(unaudited)
LIABILITIES AND SHAREHOLDERS’ EQUITY
LIABILITIES
Deposits
Noninterest Bearing Demand	$	147,865		$	141,400		$	158,967
Interest Bearing Demand	92,108			86,575			68,387
Savings and Money Market Accounts	215,293			184,597			186,182
Certificates of Deposit less than $100 thousand	195,129			228,144			232,558
Certificates of Deposit of $100 thousand or more	170,466			201,873			204,789
Brokered Deposits	88,987			165,477			193,248
Total Deposits	909,848			1,008,066			1,044,131
Federal Funds Purchased and Securities Sold under Agreements to Repurchase	12,657			12,481			14,691
Security Deposits	14			58			88
Other Liabilities	5,948			13,840			13,838
Total Liabilities	928,467			1,034,445			1,072,748
SHAREHOLDERS’ EQUITY
Preferred Stock – no par value – 10,000,000 shares authorized; no shares issued as of September 30, 2013; 33,000 issued as of December 31, 2012 and September 30, 2012; Liquidation value of $0 at September 30, 2013, $38,156 as of December 31, 2012 and $37,744 as of September 30, 2012	—			32,549			32,439
Common Stock – $.01 par value – 150,000,000 shares authorized; 66,602,601 shares issued as of September 30, 2013, 1,772,342 issued as of December 31, 2012, and 1,772,342 issued as of September 30, 2012	764			115			115
Paid-In Surplus	196,059			106,531			107,146
Common Stock Warrants	—			2,006			2,006
Unallocated ESOP Shares	—			—			(759		)
Accumulated Deficit	(103,395		)	(115,391		)	(99,291		)
Accumulated Other Comprehensive (Loss) Income	(10,040		)	3,300			3,066
Total Shareholders’ Equity	83,388			29,110			44,722
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	1,011,855		$	1,063,555		$	1,117,470

(See Accompanying Notes to Consolidated Financial Statements)

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First Security Group, Inc. and Subsidiary

Consolidated Statements of Operations

(unaudited)



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in thousands, except per share data)	2013			2012			2013			2012
INTEREST INCOME
Loans, including fees	$	6,461		$	7,722		$	19,537		$	24,289
Investment Securities – taxable	1,321			904			3,143			2,788
Investment Securities – non-taxable	312			227			749			780
Other	77			121			338			387
Total Interest Income	8,171			8,974			23,767			28,244
INTEREST EXPENSE
Interest Bearing Demand Deposits	62			52			213			128
Savings Deposits and Money Market Accounts	188			247			628			831
Certificates of Deposit of less than $100 thousand	466			657			1,551			2,063
Certificates of Deposit of $100 thousand or more	475			631			1,558			1,948
Brokered Deposits	795			1,420			2,873			4,538
Other	20			118			51			347
Total Interest Expense	2,006			3,125			6,874			9,855
NET INTEREST INCOME	6,165			5,849			16,893			18,389
(Credit) Provision for Loan and Lease Losses	(1,632		)	4,543			(1,780		)	10,492
NET INTEREST INCOME AFTER PROVISION FOR LOAN AND LEASE LOSSES	7,797			1,306			18,673			7,897
NONINTEREST INCOME
Service Charges on Deposit Accounts	798			725			2,298			2,160
Mortgage Banking Income	420			249			927			718
Gain on Sales of Securities Available-for-Sale	—			143			154			144
Other	1,296			1,577			3,876			3,967
Total Noninterest Income	2,514			2,694			7,255			6,989
NONINTEREST EXPENSES
Salaries and Employee Benefits	5,807			5,275			17,081			14,911
Expense on Premises and Fixed Assets, net of rental income	1,546			1,450			4,302			4,332
Other	4,066			6,056			16,989			18,037
Total Noninterest Expenses	11,419			12,781			38,372			37,280
LOSS BEFORE INCOME TAX PROVISION (BENEFIT)	(1,108		)	(8,781		)	(12,444		)	(22,394		)
Income Tax Provision (Benefit)	322			108			358			(402		)
NET LOSS	(1,430		)	(8,889		)	(12,802		)	(21,992		)
Preferred Stock Dividends	—			(413		)	(929		)	(1,238		)
Accretion on Preferred Stock Discount	—			(108		)	(452		)	(318		)
Effect of Exchange of Preferred Stock to Common Stock	—			—			26,179			—
NET (LOSS ALLOCATED) INCOME AVAILABLE TO COMMON SHAREHOLDERS	$	(1,430	)	$	(9,410	)	$	11,996		$	(23,548	)
NET INCOME (LOSS) PER SHARE:
Net Income (Loss) Per Share – Basic	$	(0.02	)	$	(5.79	)	$	0.30		$	(14.54	)
Net Income (Loss) Per Share – Diluted	$	(0.02	)	$	(5.79	)	$	0.30		$	(14.54	)
Dividends Declared Per Common Share	$	—		$	—		$	—		$	—

(See Accompanying Notes to Consolidated Financial Statements)

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First Security Group, Inc. and Subsidiary

Consolidated Statements of Comprehensive Loss

(unaudited)



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(in thousands)	2013			2012			2013			2012
Net loss	$	(1,430	)	$	(8,889	)	$	(12,802	)	$	(21,992	)
Other comprehensive income (loss)
Change in securities available-for-sale:
Unrealized holding (losses) gains for the period	(6,300		)	574			(13,251		)	1,033
Reclassifications for securities transferred to held-to-maturity	8,711			—			8,711			—
Reclassification adjustment for securities gains realized in income	—			(143		)	(154		)	(144		)
Income tax effect	—			—			—			—
Unrealized gains (losses) on available-for-sale securities	2,411			431			(4,694		)	889
Change in securities held-to-maturity:
Fair value adjustment for securities transferred from available-for-sale	(8,711		)	—			(8,711		)	—
Amortization of fair value for securities held-to-maturity recognized into accumulated other comprehensive income	88			—			88			—
Income tax effect	—			—			—			—
Changes from securities held-for-maturity	(8,623		)	—			(8,623		)	—
Cash flow hedges:
Net unrealized derivative (losses) gains on cash flow hedges	(95		)	257			(23		)	(37		)
Reclassification adjustment on cash flow hedges	—			(708		)	—			(1,285		)
Income tax effect	—			—			—			—
Changes from cash flow hedges	(95		)	(451		)	(23		)	(1,322		)
Other comprehensive loss, net of tax	(6,307		)	(20		)	(13,340		)	(433		)
Comprehensive loss	(7,737		)	(8,909		)	(26,142		)	(22,425		)

(See Accompanying Notes to Consolidated Financial Statements)

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First Security Group, Inc. and Subsidiary

Consolidated Statement of Shareholders’ Equity

(unaudited)



				Common Stock												Accumulated Other Comprehensive Income
(in thousands)	Preferred Stock			Shares	Amount		Paid-In Surplus			Common Stock Warrants			Accumulated Deficit			Accumulated Other Comprehensive Income			Total
Balance - December 31, 2012	$	32,549		1,772	$	115	$	106,531		$	2,006		$	(115,391	)	$	3,300		$	29,110
Net Loss	—			—	—		—			—			(12,802		)	—			(12,802		)
Other Comprehensive Loss	—			—	—		—			—			—			(13,340		)	(13,340		)
Accretion of Discount Associated with Preferred Stock	452			—	—		—			—			(452		)	—			—
Preferred Stock Dividend	—			—	—		—			—			(929		)	—			(929		)
Conversion of Preferred Stock to Common Stock in TARP Exchange	(33,001		)	9,942	99		14,814			(2,006		)	26,179			—			6,085
Common Stock Issuance, net of Offering costs of $5.3 million				50,793	508		70,388									—			70,896
Common Stock Issuance associated with Exercise of Stock Options				5	—		14												14
Common Stock Issuance associated with the Rights Offering, net of Offering costs of $764 thousand				3,329	33		4,197												4,230
Issuance of Restricted Stock and Related Expense, net of forfeitures				762	9		(9		)										—
Share-Based Compensation, net of forfeitures	—			—	—		124			—			—			—			124
Balance - September 30, 2013	$	—		66,603	$	764	$	196,059		$	—		$	(103,395	)	$	(10,040	)	$	83,388

(See Accompanying Notes to Consolidated Financial Statements)

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First Security Group, Inc. and Subsidiary

Consolidated Statements of Cash Flow

(unaudited)



	Nine Months Ended
	September 30,
(in thousands)	2013			2012
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss	$	(12,802	)	$	(21,992	)
Adjustments to Reconcile Net Loss to Net Cash Used in Operating Activities -
(Credit) Provision for Loan and Lease Losses	(1,780		)	10,492
Amortization, net	2,233			2,685
Share-Based Compensation	124			84
ESOP Compensation	—			69
Depreciation	1,315			1,056
Gain on Sales of Available-for-Sale Securities	(154		)	(144		)
Loss (Gain) on Sales of Premises and Equipment, net	18			(14		)
Loss (Gain) on Sales of Other Real Estate Owned and Repossessions, net	435			(36		)
Write-down of Other Real Estate Owned and Repossessions	1,997			4,500
Accretion of Fair Value Adjustment, net	(10		)	(39		)
Accretion of Terminated Cash Flow Swaps	—			(1,285		)
Changes in Operating Assets and Liabilities -
Loans Held for Sale	1,940			(514		)
Interest Receivable	(192		)	(404		)
Other Assets	(1,246		)	1,303
Interest Payable	(526		)	45
Other Liabilities	(2,254		)	(25		)
Net Cash Used In Operating Activities	(10,902		)	(4,219		)
CASH FLOWS USED IN INVESTING ACTIVITIES
Activity in Securities Available-for-Sale:
Maturities, Prepayments and Calls	48,476			48,175
Sales	34,181			6,952
Purchases	(179,957		)	(120,696		)
Proceeds from sales of FRB Stock	—			454
Loan Originations and Principal Collections, net	1,924			(10,047		)
Proceeds from Sales of Premises and Equipment	403			113
Proceeds from Sales of Other Real Estate and Repossessions	6,372			10,340
Proceeds from Sale of Loans to Third Party	22,296			—
Additions to Premises and Equipment	(1,242		)	(2,047		)
Capital Improvements to Other Real Estate and Repossessions	(820		)	(193		)
Net Cash Used In Investing Activities	(68,367		)	(66,949		)
CASH FLOWS FROM FINANCING ACTIVITIES
Net (Decrease) Increase in Deposits	(98,218		)	24,709
Net Increase in Federal Funds Purchased and Securities Sold Under Agreements to Repurchase	176			171
Net Decrease of Other Borrowings	—			(58		)
Net Proceeds from Issuance of Common Stock, net of offering costs	75,126			—
Proceeds from Exercise of Stock Options	14			—
Net Cash (Used in) From Financing Activities	(22,902		)	24,822
NET CHANGE IN CASH AND CASH EQUIVALENTS	(102,171		)	(46,346		)
CASH AND CASH EQUIVALENTS – beginning of period	172,471			258,181
CASH AND CASH EQUIVALENTS – end of period	$	70,300		$	211,835

(See Accompanying Notes to Consolidated Financial Statements)

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	Nine Months Ended
	September 30,
(in thousands)	2013		2012
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES
Loans and leases transferred to OREO and repossessions	$	3,778	$	7,082
Financed sales of OREO and repossessions	$	509	$	1,809
Accrued and deferred cash dividends on preferred stock	$	929	$	1,238
Effect of accrued and unpaid dividends on preferred stock redemption	$	6,085	$	—
Securities transferred from available-for-sale to held-to-maturity	$	129,076	$	—
Transfers of loans to loans held for sale at fair value	$	—	$	1,110
SUPPLEMENTAL SCHEDULE OF CASH FLOWS
Interest paid	$	7,400	$	10,003
Income taxes paid	$	—	$	70

(See Accompanying Notes to Consolidated Financial Statements)

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FIRST SECURITY GROUP, INC. AND SUBSIDIARY

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

NOTE 1 – BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Rule 8-03 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair statement of financial condition and the results of operations have been included. All such adjustments were of a normal recurring nature. Some items in the prior year financial statements were reclassified to conform to the current presentation. Reclassifications had no effect on prior year net loss or shareholders’ equity.

The consolidated financial statements include the accounts of First Security Group, Inc. ("First Security" or the "Company") and its subsidiary bank, which is wholly-owned. All significant intercompany balances and transactions have been eliminated.

Operating results for the three and nine months ended September 30, 2013 are not necessarily indicative of the results that may be expected for the year ending December 31, 2013 or any other period. These interim financial statements should be read in conjunction with the Company’s latest annual consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

NOTE 2 – MANAGEMENT'S PLANS AND REGULATORY MATTERS

Management's Plans

After execution of the primary components of the capital plan, including the Recapitalization and Rights Offering (both defined below), the Company is focused on operating under its strategic plan for the remainder of 2013. With the execution of the capital plan, as described below, combined with the ongoing performance of the strategic plan, management expects to achieve profitability and compliance with all aspects of the regulatory agreements over the next six to twelve months.

On April 11, 2013, the Company completed a restructuring of the Company's Preferred Stock with the U.S. Treasury ("Treasury") by issuing $14.9 million of new common stock for $1.50 per share for the full satisfaction of the Treasury's 2009 investment in the Company. Pursuant to the exchange agreement ("Exchange Agreement"), as previously included in a Current Report on Form 8-K filed on February 26, 2013, the Company restructured the Company's Preferred Stock issued under the Capital Purchase Program ("CPP") of the Troubled Asset Relief Program ("TARP") by issuing new shares of common stock equal to 26.75% of the $33 million value of the Preferred Stock plus 100% of the accrued but unpaid dividends in exchange for the Preferred Stock, all accrued but unpaid dividends thereon, and the cancellation of stock warrants granted in connection with the CPP investment ("CPP Restructuring"). Immediately after the issuance of the common stock to the Treasury, the Treasury sold all of the Company's common stock to investors previously identified by the Company at the same $1.50 per share price.

On April 12, 2013, the Company completed the issuance of an additional $76.2 million of new common stock in a private placement to accredited investors. The private placement was previously announced on a Current Report on Form 8-K filed on February 26, 2013, in which the Company announced the execution of definitive stock purchase agreements with institutional investors as part of an approximately $90 million recapitalization ("Recapitalization"). In total, the Company issued 60,735,000 shares of common stock at $1.50 per share for gross proceeds of $91.1 million.

As part of the Recapitalization, the Company initiated a rights offering (the "Rights Offering") during the third quarter of 2013 for shareholders of record as of April 10, 2013, the business day immediately preceding the Recapitalization (the "Legacy Shareholders"). The Rights Offering was previously announced on a Current Report on Form 8-K filed on February 26, 2013. Under the Rights Offering each Legacy Shareholder received one non-transferable subscription right to purchase two shares of the Company's common stock at the subscription price of $1.50 per share for every one share of common stock owned by such Legacy Shareholder as of the record date of April 10, 2013. Additionally, each Legacy Shareholder that fully exercised such Legacy Shareholder's subscription rights had the ability to submit an over-subscription request to purchase additional shares of common stock, subject to certain limitations and subject to allotment under the Rights Offering. On September 27, 2013, the Company completed the Rights Offering issuing 3,329,234 shares of common stock for $1.50 per share for gross proceeds of approximately $5.0 million. The Company downstreamed the net proceeds to supplement the capital of FSGBank.

During the second quarter of 2013, the Company began deploying its excess liquidity into higher earning assets. The Company deployed approximately $83.6 million of cash into the investment security portfolio during the second quarter of 2013. As of September 30, 2013, the Company reported in excess of $70 million in cash. The Company will continue to execute the strategic plan, including the balance sheet restructuring and deployment of cash, over the remainder of 2013.

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Regulatory Matters

First Security Group, Inc.

On September 7, 2010, the Company entered into a Written Agreement (the "Agreement") with the Federal Reserve Bank of Atlanta (the "Federal Reserve"), the Company’s primary regulator. The Agreement is designed to enhance the Company’s ability to act as a source of strength to the Company's wholly owned subsidiary, FSGBank, National Association ("FSGBank" or the "Bank").

The Agreement prohibits the Company from declaring or paying dividends without prior written consent of the Federal Reserve. The Company is also prohibited from taking dividends, or any other form of payment representing a reduction of capital, from the Bank without prior written consent.

Within 60 days of the Agreement, the Company was required to submit to the Federal Reserve a written plan designed to maintain sufficient capital at the Company and the Bank. The Company submitted a copy of the Bank’s capital plan that had previously been submitted to the Bank’s primary regulator, the Office of the Comptroller of the Currency ("OCC"). Neither the Federal Reserve nor the OCC accepted the initially submitted capital plan. Strategic and capital plans covering three years were revised to reflect the actual terms and timing of the Recapitalization and Rights Offering and submitted to the OCC and Federal Reserve.

The Company is currently deemed not in compliance with certain provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve. Management believes the successful execution of the strategic initiatives discussed below will ultimately result in full compliance with the Agreement and position the Company for long-term growth and a return to profitability.

On September 14, 2010, the Company filed a Current Report on Form 8-K describing the Agreement. A copy of the Agreement is filed as Exhibit 10.1 to such Form 8-K. The foregoing summary is not complete and is qualified in all respects by reference to the actual language of the Agreement.

FSGBank, N.A.

On April 28, 2010, pursuant to a Stipulation and Consent to the Issuance of a Consent Order, FSGBank consented and agreed to the issuance of a Consent Order by the OCC (the "Order").

The Bank and the OCC agreed to the areas of the Bank’s operations that warrant improvement and on a plan for making those improvements. The Order required the Bank to develop and submit written strategic and capital plans covering at least a three years period. The Board of Directors is required to ensure that competent management is in place in all executive officer positions to manage the Bank in a safe and sound manner. The Bank is also required to review and revise various policies and procedures, including those associated with credit concentration management, the allowance for loan and lease losses, liquidity management, criticized assets, loan review and credit. The Bank is continuing to work with the OCC to ensure the policies and procedures are both appropriate and fully implemented.

Within 120 days of the effective date of the Order, the Bank was required to achieve and thereafter maintain total capital at least equal to 13.0% of risk-weighted assets and Tier 1 capital at least equal to 9.0% of adjusted total assets (also referred to as the leverage ratio). As of September 30, 2013, the thirteenth financial reporting period subsequent to the 120 day requirement, the Bank’s total capital to risk-weighted assets was 14.9% and the Tier 1 capital to adjusted total assets was 8.3%. The Bank has notified the OCC of its compliance of the total risk-based capital ratio and non-compliance with the Tier 1 leverage capital requirements of the Order.

Effective with the Order, the Bank has been restricted from paying interest on deposits that is more than 0.75% above the rate applicable to the applicable market of the Bank as determined by the Federal Deposit Insurance Corporation ("FDIC"). Additionally, the Bank may not accept, renew or roll over brokered deposits without prior approval of the FDIC.

Based on the last regulatory examination, the Bank is currently deemed not in compliance with certain provisions of the Order, including the capital requirements. Management believes that the completed Recapitalization and Rights Offering as well as the full implementation of the business plan will provide compliance with most requirements of the Order. However, in determining full compliance, multiple factors may be considered, including a certain period of time after implementation. Accordingly, we can provide no assurances as to the timing, if at all, of relief from the Order.

On April 29, 2010, the Company filed a Current Report on Form 8-K describing the Order. A copy of the Order is filed as Exhibit 10.1 to such Form 8-K. The foregoing summary is not complete and is qualified in all respects by reference to the actual language of the Order.

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Regulatory Capital Ratios

Banks and bank holding companies, as regulated institutions, must maintain required levels of capital. The OCC and the Federal Reserve, the primary federal regulators for FSGBank and the Company, respectively, have adopted minimum capital regulations or guidelines that categorize components and the level of risk associated with various types of assets. Financial institutions are expected to maintain a level of capital commensurate with the risk profile assigned to their assets in accordance with the guidelines. As described above, the Order requires FSGBank to achieve and maintain total capital to risk adjusted assets of at least 13.0% and a leverage ratio of at least 9.0%. The Order provided 120 days from April 28, 2010, the effective date of the Order, to achieve these ratios. FSGBank is currently in compliance with the total capital to risk adjusted assets ratio but remains not in compliance with the leverage ratio capital requirement.

As of September 30, 2012, the Bank's Tier 1 leverage ratio fell below the minimum level for an "adequately capitalized" bank of 4%. As of December 31, 2012, the Bank was reclassified from "undercapitalized" to "significantly undercapitalized" upon the filing of the Call Report on January 30, 2013 and further reclassified to "critically undercapitalized" upon the filing of the Call Report for the period ended March 31, 2013 on April 30, 2013.

The Bank was upgraded to "adequately capitalized" during May 2013. On April 23, 2013, FSGBank filed a cash contribution to capital notice with the OCC certifying a $65 million capital contribution by First Security Group into FSGBank. On September 27, 2013, First Security Group provided an additional $6.4 million cash contribution to FSGBank, consisting of the net proceeds from the Rights Offering as well as additional available cash. With the capital contributions, FSGBank's regulatory capital ratios as of September 30, 2013 were as follows: Tier 1 leverage ratio of 8.33% and total risk-based capital of 14.94%. All regulatory capital ratios exceed the percentages of a well capitalized institution as defined under applicable regulatory guidelines; however, FSGBank will continue to be classified as adequately capitalized due to the capital requirement in the Order.

The following table compares the required capital ratios maintained by the Company and FSGBank:

CAPITAL RATIOS



September 30, 2013	FSGBank Consent Order¹		Minimum Capital Requirements under Prompt Corrective Action Provisions		First Security		FSGBank
Tier 1 capital to risk adjusted assets	n/a		4.0	%	14.59	%	13.68	%
Total capital to risk adjusted assets	13.0	%	8.0	%	15.84	%	14.94	%
Leverage ratio	9.0	%	4.0	%	8.95	%	8.33	%

December 31, 2012
Tier 1 capital to risk adjusted assets	n/a		4.0	%	4.23	%	4.54	%
Total capital to risk adjusted assets	13.0	%	8.0	%	5.49	%	5.80	%
Leverage ratio	9.0	%	4.0	%	2.31	%	2.48	%

September 30, 2012
Tier 1 capital to risk adjusted assets	n/a		4.0	%	6.80	%	7.00	%
Total capital to risk adjusted assets	13.0	%	8.0	%	8.10	%	8.30	%
Leverage ratio	9.0	%	4.0	%	3.70	%	3.80	%

_____________

¹ FSGBank was required to achieve and maintain these capital ratios within 120 days from April 28, 2010.

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NOTE 3 –OTHER COMPREHENSIVE INCOME (LOSS)

Other comprehensive income (loss) for the Company consists of changes in net unrealized gains and losses on investment securities available-for-sale and derivatives. The following tables present a summary of the changes in accumulated other comprehensive income balances for the applicable periods.



Changes in Other Comprehensive Income from June 30, 2013 to September 30, 2013

	Unrealized Gain (Loss) on Derivatives			Unrealized Gain (Loss) on Available-for-Sale Securities			Unrealized Gain (Loss) on Held-to-Maturity Securities			Accumulated Other Comprehensive Income (Loss)
	(in thousands)
Beginning balance, June 30, 2013	$	18		$	(3,751	)	$	—		$	(3,733	)
Other comprehensive loss before reclassifications	(95		)	(6,300		)	88			(6,307		)
Reclassifications for securities transferred to held-to-maturity	—			8,711			(8,711		)	—
Amounts reclassified from accumulated other comprehensive loss into earnings	—			—			—			—
Net current period other comprehensive income (loss)	(95		)	2,411			(8,623		)	(6,307		)
Ending balance, September 30, 2013	$	(77	)	$	(1,340	)	$	(8,623	)	$	(10,040	)



Changes in Other Comprehensive Income from June 30, 2012 to September 30, 2012

	Unrealized Gain (Loss) on Derivatives			Unrealized Gain (Loss) on Available-for-sale Securities		Accumulated Other Comprehensive Income (Loss)
	(in thousands)
Beginning balance, June 30, 2012	$	(669	)	$	3,755	$	3,086
Other comprehensive income before reclassification	257			288		545
Amounts reclassified from accumulated other comprehensive income	(708		)	143		(565		)
Net current period other comprehensive (loss) income	(451		)	431		(20		)
Ending balance, September 30, 2012	$	(1,120	)	$	4,186	$	3,066

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Changes in Other Comprehensive Income from December 31, 2012 to September 30, 2013

	Unrealized Gain (Loss) on Derivatives			Unrealized Gain (Loss) on Available-for-Sale Securities			Unrealized Gain (Loss) on Held-to-Maturity Securities			Accumulated Other Comprehensive Income (Loss)
	(in thousands)
Beginning balance, December 31, 2012	$	(54	)	$	3,354		$	—		$	3,300
Other comprehensive loss before reclassification	(23		)	(13,559		)	88			(13,494		)
Reclassifications for securities transferred to held-to-maturity	—			8,711			(8,711		)	—
Amounts reclassified from accumulated other comprehensive loss into earnings	—			154			—			154
Net current period other comprehensive income (loss)	(23		)	(4,694		)	(8,623		)	(13,340		)
Ending balance, September 30, 2013	$	(77	)	$	(1,340	)	$	(8,623	)	$	(10,040	)



Changes in Other Comprehensive Income from December 31, 2011 to September 30, 2012

	Unrealized Gain (Loss) on Derivatives			Unrealized Gain (Loss) on Available-for-sale Securities		Accumulated Other Comprehensive Income (Loss)
	(in thousands)
Beginning balance, December 31, 2011	$	202		$	3,297	$	3,499
Other comprehensive income before reclassification	(37		)	745		708
Amounts reclassified from accumulated other comprehensive income	(1,285		)	144		(1,141		)
Net current period other comprehensive (loss) income	(1,322		)	889		(433		)
Ending balance, September 30, 2012	$	(1,120	)	$	4,186	$	3,066

For the three and nine months ended September 30, 2013, no amounts were reclassified into interest income due to gains on derivatives. For the three and nine months ended September 30, 2012, $708 thousand and $1.285 million, respectively, were reclassified into interest income due to gains on derivatives. For the three months ended September 30, 2013, there were no reclassifications from gains or losses on securities. For the nine months ended September 30, 2013, there were $154 thousand of gains reclassified from unrealized gains on available-for-sale securities to earnings as a result of sales during the period. For the three and nine months ended September 30, 2012, there were $143 thousand and $144 thousand, respectively, of gains on available-for-sale securities reclassified to earnings.

During the three months ended September 30, 2013, approximately $129 million of available-for-sale securities were transferred to the held-to-maturity classification. As of the transfer date, the securities held an unrealized loss of approximately $8.7 million. The fair value as of the transfer date became the new amortized cost basis with the unrealized loss, along with any remaining purchase discount or premium, being reclassified into accumulated other comprehensive income over the remaining life of the security. For the three months ended September 30, 2013, approximately $88 thousand of the unrealized loss was reclassified into other comprehensive income.

NOTE 4 –SHARE-BASED COMPENSATION

As of September 30, 2013, the Company has three share-based compensation plans, the 2012 Long-Term Incentive Plan (the 2012 LTIP), the 2002 Long-Term Incentive Plan (the 2002 LTIP) and the 1999 Long-Term Incentive Plan (the 1999 LTIP). The plans are administered by the Compensation Committee of the Board of Directors (the Committee), which selects persons eligible to receive awards and determines the number of shares and/or options subject to each award, the terms, conditions and other provisions of the award. The plans are described in further detail below.

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During the Company's participation in TARP CPP, the terms of awards were also subject to compliance with applicable TARP compensation regulations.

The 2012 LTIP was approved by the shareholders of the Company at the 2012 annual meeting as previously reported on a Current Report on Form 8-K filed June 26, 2012 and subsequently amended at the 2013 annual meeting as reported on a Current Report on Form 8-K filed on July 26, 2013. The amendment increased the shares reserved for issuance from 175,000 shares to 6,250,000 shares and was effective on July 24, 2013. The 2012 Long-Term Incentive Plan permits the Committee to make a variety of awards, including incentive and nonqualified options to purchase shares of First Security's common stock, stock appreciation rights, other share-based awards which are settled in either cash or shares of First Security's common stock and are determined by reference to shares of stock, such as grants of restricted common stock, grants of rights to receive stock in the future, or dividend equivalent rights, and cash performance awards, which are settled in cash and are not determined by reference to shares of First Security's common stock (Awards). These discretionary Awards may be made on an individual basis or through a program approved by the Committee for the benefit of a group of eligible persons. As of September 30, 2013, the number of shares available under the 2012 LTIP for future grants was 3,219,275.

The 2002 LTIP was approved by the shareholders of the Company at the 2002 annual meeting and subsequently amended by the shareholders of the Company at the 2004 and 2007 annual meetings to increase the number of shares available for issuance under the 2002 LTIP by 480 thousand and 750 thousand shares, respectively. The total number of shares authorized for awards prior to the 10-for-1 reverse stock split was 1.5 million. As a result of the 10-for-1 reverse stock split in 2011, the total shares currently authorized under the 2002 LTIP is 151,800, of which not more than 20% may be granted as awards of restricted stock. Eligible participants include eligible employees, officers, consultants and directors of the Company or any affiliate. The exercise price per share of a stock option granted may not be less than the fair market value as of the grant date. The exercise price must be at least 110% of the fair market value at the grant date for options granted to individuals, who at the grant date, are 10% owners of the Company’s voting stock (each a 10% owner). Restricted stock may be awarded to participants with terms and conditions determined by the Committee. The term of each award is determined by the Committee, provided that the term of any incentive stock option may not exceed ten years (five years for 10% owners) from its grant date. Each option award vests in approximately equal percentages each year over a period of not less than three years from the date of grant as determined by the Committee subject to accelerated vesting under terms of the 2002 LTIP or as provided in any award agreement. As of September 30, 2013, there are no shares available for future grants under the 2002 LTIP.

Participation in the 1999 LTIP is limited to eligible employees. The total number of shares of stock authorized for awards prior to the 10-for-1 reverse stock split was 936 thousand. As a result of the 10-for-1 reverse stock split in 2011, the total shares currently authorized under the 1999 LTIP is 93,600, of which not more than 10% could be granted as awards of restricted stock. Under the terms of the 1999 LTIP, incentive stock options to purchase shares of the Company’s common stock may not be granted at a price less than the fair market value of the stock as of the date of the grant. Options must be exercised within ten years from the date of grant subject to conditions specified by the 1999 LTIP. Restricted stock could also be awarded by the Committee in accordance with the 1999 LTIP. Generally, each award vests in approximately equal percentages each year over a period of not less than three years and vest from the date of grant as determined by the Committee subject to accelerated vesting under terms of the 1999 LTIP or as provided in any award agreement. As of September 30, 2013, there are no shares available for future grants under the 1999 LTIP.

Stock Options

The following table illustrates the effect on operating results for share-based compensation for the three and nine months ended September 30, 2013 and 2012.



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
	(in thousands)
Stock option compensation expense	$	88	$	2	$	149	$	3
Stock option compensation expense, net of tax ¹	$	58	$	1	$	98	$	2

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¹Due to the deferred tax valuation allowance, tax benefit is reversed through the valuation allowance.

During the nine months ended September 30, 2013, 5,000 shares were exercised for gross proceeds of $14 thousand. No options were exercised in three months ended September 30, 2013 or in the nine months ended September 30, 2012.

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The fair value of each option award is estimated on the date of grant using a closed form option valuation (Black-Scholes) model that uses the following assumptions: expected dividend yield, expected volatility, risk-free interest rate, expected life of the option and the grant date fair value. Expected volatilities were based on historical volatilities of the Company's common stock. During 2013, the Company utilized a regional bank index to determine expected volatilities. The Company uses historical data to estimate option exercise and post-vesting termination behavior. The expected term of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding, which takes into account that the options are not transferable. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of the grant.

Options granted during the nine months ended September 30, 2013 totaled 2.2 million. The fair value of options granted during the nine months ended September 30, 2013 and September 30, 2012 was determined using the following weighted-average assumptions as of the grant date.



	As of September 30, 2013		As of September 30, 2012
Risk-free interest rate	2.00	%	1.29	%
Expected term, in years	6.5		6.5
Expected stock price volatility	44.09	%	67.89	%
Dividend yield	—	%	—	%

The following table represents stock option activity for the nine months ended September 30, 2013:



	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term (in years)	Aggregate Intrinsic Value
Outstanding, January 1, 2013	135,176		$	25.54
Granted	2,158,250		$	2.33
Exercised	(5,000	)	$	2.80
Forfeited	(9,616	)	$	74.00
Outstanding, September 30, 2013	2,278,810		$	3.40	9.69	$	—
Exercisable, September 30, 2013	56,396		$	44.93	5.91	—		¹

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¹ As of September 30, 2013, the exercise price of all exercisable options exceeded the closing price of the Company's common stock of $2.17, resulting in no intrinsic value.

As of September 30, 2013, shares available for future option grants to employees and directors under existing plans were zero, zero and 3,219,275 for the 1999 LTIP, 2002 LTIP and 2012 LTIP, respectively.

As of September 30, 2013, there was $2.3 million of total unrecognized compensation cost related to nonvested stock options granted under the Plans. The cost is expected to be recognized over a weighted-average period of 2.76 years.

Restricted Stock

The Plans described above allow for the issuance of restricted stock awards that may not be sold or otherwise transferred until certain restrictions have lapsed. The unearned share-based compensation related to these awards is being amortized to compensation expense over the period the restrictions lapse. The share-based expense for these awards was determined based on the market price of the Company’s stock at the grant date applied to the total number of shares that were anticipated to fully vest and then amortized over the vesting period.

On April 11, 2013, approximately 107,175 restricted stock shares or 75% of all unvested restricted stock awards to employees were forfeited in connection with the application of TARP CPP regulations to the Recapitalization. As none of these shares had vested, the reversal of previously recognized expense was recorded during the quarter of the forfeitures.

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As of September 30, 2013, unearned share-based compensation associated with these awards totaled $2.0 million. The Company recognized compensation expense (benefit), net of forfeitures, of $109 thousand and $(25) thousand for the three and nine months ended September 30, 2013, respectively and $31 thousand and $53 thousand for the three and nine months ended September 30, 2012, respectively, related to the amortization of deferred compensation that was included in salaries and benefits in the accompanying consolidated statements of operations. The remaining cost is expected to be recognized over a weighted-average period of 2.74 years.

The following table represents restricted stock activity for the period ended September 30, 2013:



	Shares			Weighted Average Grant-Date Fair Value
Nonvested shares at January 1, 2013	129,781			$	2.85
Granted	874,900			$	2.33
Vested	(40	)
Forfeited	(113,875	)
Nonvested, September 30, 2013	890,766		¹	$	2.35

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¹ Includes 23,250 shares issued as an inducement grant from available and unissued shares and not from the Plans.

NOTE 5 – EARNINGS (LOSS) PER SHARE

The difference in basic and diluted weighted average shares is due to the assumed conversion of outstanding stock options, restricted stock awards and common stock warrants using the treasury stock method. The Company has issued certain restricted stock awards, which are unvested share-based payment awards that contain non-forfeitable rights to dividends or dividend equivalents. These restricted shares are considered participating securities. Accordingly, the Company calculated net income available to common shareholders pursuant to the two-class method, whereby net income is allocated between common shareholders and participating securities. In periods of a net loss, no allocation is made to participating securities as they are not contractually required to fund net losses. The computation of basic and diluted earnings per share is as follows:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013			2012			2013			2012
	(in thousands, except per share amounts)
Numerator:
Net loss	$	(1,430	)	$	(8,889	)	$	(12,802	)	$	(21,992	)
Preferred stock dividends	—			(413		)	(929		)	(1,238		)
Accretion of preferred stock discount	—			(108		)	(452		)	(318		)
Dividends and undistributed earnings allocated on participating securities	—			—			(88		)	—
Effect of exchange of preferred stock to common stock	—			—			26,179			—
Net income (loss) allocated to common shareholders	$	(1,430	)	$	(9,410	)	$	11,908		$	(23,548	)
Denominator:
Weighted average common shares outstanding including participating securities	63,280			1,753			40,317			1,731
Less: Participating securities	680			127			297			112
Weighted average basic common shares outstanding	62,600			1,626			40,020			1,619
Effect of diluted securities:
Equivalent shares issuable upon exercise of stock options, stock warrants and restricted stock awards	—			—			—			—
Weighted average diluted common shares outstanding	62,600			1,626			40,020			1,619
Net earnings (loss) per share:
Basic	$	(0.02	)	$	(5.79	)	$	0.30		$	(14.54	)
Diluted	$	(0.02	)	$	(5.79	)	$	0.30		$	(14.54	)

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For the three and nine months ended September 30, 2013, there were no equivalent shares included in the computation of diluted earnings per share. Due to the net loss allocated to common shareholders for both prior periods shown, all stock options, stock warrants and restricted stock grants are considered anti-dilutive and are not included in the computation of diluted earnings per share for the three and nine months ended September 30, 2012. As of September 30, 2013 and September 30, 2012 a total of 3.2 million and 327 thousand stock options, stock warrants and restricted stock grants were considered anti-dilutive, respectively.

NOTE 6 – SECURITIES

Investment Securities by Type

The following table presents the amortized cost and fair value of securities available-for-sale and the corresponding amounts of gross unrealized gains and losses recognized in accumulated other comprehensive income.



	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Available-for-sale	(in thousands)
September 30, 2013
Debt securities—
Federal agencies	$	6,177	$	208	$	251	$	6,134
Mortgage-backed—residential	146,521		1,849		1,942		146,428
Municipals	33,336		548		504		33,380
Other	21,343		21		297		21,067
Total	$	207,377	$	2,626	$	2,994	$	207,009

December 31, 2012
Debt securities—
Federal agencies	$	57,393	$	256	$	104	$	57,545
Mortgage-backed—residential	157,191		3,424		138		160,477
Municipals	35,088		1,028		122		35,994
Other	61		—		20		41
Total	$	249,733	$	4,708	$	384	$	254,057

September 30, 2012
Debt securities—
Federal agencies	$	32,286	$	163	$	2	$	32,447
Mortgage-backed—residential	190,702		4,130		167		194,665
Municipals	29,057		1,158		106		30,109
Other	61		—		19		42
Total	$	252,106	$	5,451	$	294	$	257,263

The following table presents the amortized cost and fair value of securities held-to-maturity and the corresponding amounts of gross unrecognized gains and losses.



	Amortized Cost		Gross Unrecognized Gains		Gross Unrecognized Losses		Fair Value
Held-to-maturity	(in thousands)
September 30, 2013
Debt securities—
Federal agencies	$	61,292	$	447	$	214	$	61,525
Mortgage-backed—residential	40,271		377		47		40,601
Municipals	27,601		572		129		28,044
Total	$	129,164	$	1,396	$	390	$	130,170

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During the third quarter of 2013, federal agency, mortgage-backed residential and municipal securities with a fair value of $129.1 million were transferred from the available-for-sale portfolio to the held-to-maturity portfolio. The $8.7 million unrealized holding loss at the date of transfer will continue to be reported as a separate component of shareholders' equity and will be amortized over the remaining life of the securities as an adjustment of yield. The corresponding discount on these securities will offset this adjustment to yield as it is amortized.

During the three months ended September 30, 2013, the Company had no sales of securities. During the nine months ended September 30, 2013, the Company sold one federal agency security resulting in proceeds of $1.0 million and gross gains of less than $1 thousand and sold 54 mortgage backed securities resulting in proceeds of approximately $33.2 million, gross gains of $344 thousand and gross losses of $190 thousand. During the three months ended September 30, 2012, the Company sold 21 municipal securities and one mortgage-backed security resulting in proceeds of $6.7 million and gross gains of $143 thousand. During the the nine months ended September 30, 2012, the Company sold 22 municipal securities and one mortgage-backed security for $7.0 million and a gross gain of $144 thousand.

At September 30, 2013, December 31, 2012 and September 30, 2012, available-for-sale securities with a carrying value of $35.1 million, $28.1 million and $28.7 million, respectively, were pledged to secure public deposits. At September 30, 2013, December 31, 2012 and September 30, 2012, the carrying amount of available-for-sale securities pledged to secure repurchase agreements was $19.6 million, $18.5 million and $18.6 million, respectively. At September 30, 2013, December 31, 2012 and September 30, 2012, available-for-sale securities of $6.9 million, $6.5 million and $6.6 million were pledged to the Federal Reserve Bank of Atlanta to secure the Company’s daytime correspondent transactions. At September 30, 2013, December 31, 2012 and September 30, 2012 the carrying amount of available-for-sale securities pledged to secure lines of credit with the Federal Home Loan Bank (the "FHLB") totaled $53.3 million, $5.5 million and $10.8 million, respectively. At September 30, 2013, pledged and unpledged available-for-sale securities totaled $90.3 million and $116.7 million, respectively.

Maturity of Securities

The following table presents the amortized cost and fair value of debt securities by contractual maturity at September 30, 2013.



	Available-For-Sale				Held-To-Maturity
	Amortized Cost		Fair Value		Amortized Cost		Fair Value
	(in thousands)
Within 1 year	$	1,591	$	1,611	$	—	$	—
Over 1 year through 5 years	11,725		12,014		7,003		6,813
5 years to 10 years	27,467		27,126		58,886		60,885
Over 10 years	20,073		19,830		23,004		21,871
	60,856		60,581		88,893		89,569
Mortgage-backed residential securities	146,521		146,428		40,271		40,601
Total	$	207,377	$	207,009	$	129,164	$	130,170

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Impairment Analysis

The following table shows the gross unrealized losses and fair value of the Company’s available-for-sale investments with unrealized losses and the gross unrecognized losses and fair value of the Company's held-to-maturity investments that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at September 30, 2013, December 31, 2012 and September 30, 2012.



	Less than 12 months				12 months or greater				Totals
	Fair Value		Unrealized Losses		Fair Value		Unrealized Losses		Fair Value		Unrealized Losses
Available-For-Sale	(in thousands)
September 30, 2013
Federal agencies	$	13,043	$	251	$	—	$	—	$	13,043	$	251
Mortgage-backed—residential	82,545		1,942		—		—		82,545		1,942
Municipals	13,377		504		—		—		13,377		504
Other	16,991		291		55		6		17,046		297
Totals	$	125,956	$	2,988	$	55	$	6	$	126,011	$	2,994
December 31, 2012
Federal agencies	$	20,199	$	104	$	—	$	—	$	20,199	$	104
Mortgage-backed—residential	15,509		138		—		—		15,509		138
Municipals	8,012		122		—		—		8,012		122
Other	—		—		41		20		41		20
Totals	$	43,720	$	364	$	41	$	20	$	43,761	$	384
September 30, 2012
Federal agencies	$	998	$	2	$	—	$	—	$	998	$	2
Mortgage-backed—residential	29,165		167		—		—		29,165		167
Municipals	5,796		106		—		—		5,796		106
Other	—		—		42		19		42		19
Totals	$	35,959	$	275	$	42	$	19	$	36,001	$	294



	Less than 12 months				12 months or greater				Totals
	Fair Value		Unrecognized Losses		Fair Value		Unrecognized Losses		Fair Value		Unrecognized Losses
Held-To-Maturity	(in thousands)
September 30, 2013
Federal agencies	$	13,919	$	214	$	—	$	—	$	13,919	$	214
Mortgage-backed—residential	17,552		47		—		—		17,552		47
Municipals	4,225		129		—		—		4,225		129
Other	—		—		—		—		—		—
Totals	$	35,696	$	390	$	—	$	—	$	35,696	$	390

There were no securities held-to-maturity for the periods ended December 31, 2012 and September 30, 2012.

As of September 30, 2013, the Company performed an impairment assessment of the available-for-sale securities in its portfolio that had unrealized losses and the held-to-maturity portfolio that had unrecognized losses to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) the Company intends to sell the security, (2) it is more likely than not that the Company will be required to sell the security before recovery of its amortized costs basis or (3) the Company does not expect to recover the security’s entire amortized cost basis, even if the Company does not intend to sell. Additionally, accounting guidance requires that for impaired available-for-sale securities that the Company

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does not intend to sell and/or that it is not more-likely-than-not that the Company will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. Losses related to held-to-maturity securities are not recorded, as these securities are carried at their amortized cost. If a decline is determined to be other-than-temporary due to credit losses, the cost basis of the individual available-for-sale or held-to-maturity security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.

In evaluating the recovery of the entire amortized cost basis, the Company considers factors such as (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, including events specific to the issuer or industry, (3) defaults or deferrals of scheduled interest, principal or dividend payments and (4) external credit ratings and recent downgrades.

As of September 30, 2013, gross unrealized losses in the Company’s available-for-sale portfolio totaled $3.0 million, compared to $384 thousand as of December 31, 2012 and $294 thousand as of September 30, 2012. As of September 30, 2013, gross unrecognized losses in the Company's held-to-maturity portfolio totaled $390 thousand. As of September 30, 2013, the available-for-sale securities unrealized losses in mortgage-backed securities (consisting of thirty-two securities), municipals (consisting of twenty-six securities) and federal agencies (consisting of one securities) and the held-to-maturity unrecognized losses in mortgage-backed securities (consisting of six securities), municipals (consisting of eleven securities) and federal agencies (consisting of eleven securities) are primarily due to widening credit spreads and changes in interest rates subsequent to purchase. Between December 31, 2012 and September 30, 2013, the rate on the 10-year U.S. Treasury increased from approximately 1.78% to 2.64%. As this represented a substantive increase in interest rates, the market valuation of the Company's securities adjusted accordingly. The unrealized loss in other available-for-sale securities relates to nine corporate notes and one pooled trust preferred security. The unrealized loss in the corporate notes is primarily due to changes in interest rates subsequent to purchase. The unrealized loss in the pooled trust preferred security is primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. The Company does not intend to sell the available-for-sale investments with unrealized losses and it is not more likely than not that the Company will be required to sell the available-for-sale investments before recovery of their amortized cost basis, which may be maturity. Based on results of the Company’s impairment assessment, the unrealized losses related to the available-for-sale securities and the unrecognized losses related to the held-to-maturity securities at September 30, 2013 are considered temporary.

NOTE 7 – LOANS HELD FOR SALE

On December 10, 2012, the Company entered into an asset purchase agreement with a third party to sell certain loans. During the fourth quarter of 2012, the Company identified $36.2 million of under- and non-performing loans to sell and recorded a $13.9 million loss to reduce the loan balance to the expected net proceeds. Loans held-for-sale due to the asset purchase agreement totaled approximately $22.3 million at December 31, 2012. The Loan sale was completed during February 2013.

Other loans held-for-sale consisted of residential 1-4 family loans and totaled $1.7 million, $3.6 million and $3.9 million at September 30, 2013, December 31, 2012 and September 30, 2012, respectively. In the tables below, the residential 1-4 family real estate loans have been split out between loan originated to be held-for-sale and those loans that were transferred into the loans held-for-sale category. Amounts listed in all other loan categories are from loans transferred to loans held-for-sale.

Loans held for sale by type are summarized as follows:



	September 30, 2013		December 31, 2012		September 30, 2012
Loans secured by real estate—	(in thousands)
Residential 1-4 family originated to be held-for-sale	$	1,661	$	3,624	$	3,857
Residential 1-4 family transferred to held-for-sale	—		7,964		—
Commercial	—		6,906		—
Construction	—		2,537		—
Multi-family and farmland	—		3,962		—
Total Real Estate	1,661		24,993		3,857
Commercial loans	—		895		—
Consumer installment loans	—		32		—
Total loans held for sale	$	1,661	$	25,920	$	3,857

Table of Contents

Loans held-for-sale at September 30, 2013 and 2012 of $1.7 million and $3.9 million, respectively, were all rated as pass. The following table presents the Company’s internal risk rating by loan classification for loans held for sale as of December 31, 2012:



	Pass		Special Mention		Substandard – Non-impaired		Substandard – Impaired		Total
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family originated to be held-for-sale	$	3,624	$	—	$	—	$	—	$	3,624
Real estate: Residential 1-4 family transferred to held-for-sale	264		511		4,229		2,960		7,964
Real estate: Commercial	—		438		2,922		3,546		6,906
Real estate: Construction	23		16		754		1,744		2,537
Real estate: Multi-family and farmland	281		—		2,788		893		3,962
Commercial	21		—		372		502		895
Consumer	22		—		2		8		32
Total Loans	$	4,235	$	965	$	11,067	$	9,653	$	25,920

Nonaccrual loans held for sale were $13.4 million at December 31, 2012. There were no non-accrual loans held for sale at September 30, 2013 or 2012. The following table provides nonaccrual loans held for sale by type:



	As of December 31, 2012
	(in thousands)
Nonaccrual Loans by Classification
Real estate: Residential 1-4 family	$	5,311
Real estate: Commercial	4,336
Real estate: Construction	1,967
Real estate: Multi-family and farmland	1,152
Commercial	580
Consumer and other	27
Total Loans	$	13,373

All nonaccrual loans in the held-for-sale category are from loans transferred to loans held-for-sale and not from loans that were originated to be sold.

Table of Contents

The following table provides the past due status for all loans held for sale as of December 31, 2012. Nonaccrual loans are included in the applicable classification. There were no past due loans held for sale at September 30, 2013 or 2012.

As of December 31, 2012



	30-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total		Greater than 90 Days Past Due and Accruing
	(in thousands)
Loans by Classification
Residential 1-4 family originated to be held-for-sale	$	—	$	—	$	—	$	3,624	$	3,624	$	—
Residential 1-4 family transferred to held-for-sale	436		697		1,133		6,831		7,964		697
Real estate: Commercial	63		—		63		6,843		6,906		—
Real estate: Construction	16		—		16		2,521		2,537		—
Real estate: Multi-family and farmland	1,428		—		1,428		2,534		3,962		—
Subtotal of real estate secured loans	1,943		697		2,640		22,353		24,993		697
Commercial	292		21		313		582		895		21
Consumer	—		—		—		32		32		—
Leases	—		—		—		—		—		—
Other	—		—		—		—		—		—
Total Loans	$	2,235	$	718	$	2,953	$	22,967	$	25,920	$	718

NOTE 8 – LOANS AND ALLOWANCE FOR LOAN AND LEASE LOSSES

Loans by type are summarized in the following table.



	September 30, 2013			December 31, 2012			September 30, 2012
Loans secured by real estate—	(in thousands)
Residential 1-4 family	$	173,446		$	188,191		$	200,566
Commercial	222,603			221,655			232,470
Construction	42,364			33,407			37,744
Multi-family and farmland	18,844			17,051			24,075
	457,257			460,304			494,855
Commercial loans	50,879			61,398			58,045
Consumer installment loans	21,586			13,387			14,757
Leases, net of unearned income	42			568			771
Other	4,863			5,473			4,937
Total loans	534,627			541,130			573,365
Allowance for loan and lease losses	(10,700		)	(13,800		)	(17,490		)
Net loans	$	523,927		$	527,330		$	555,875

The allowance for loan and lease losses is composed of two primary components: (1) specific impairments for substandard/nonaccrual loans and leases and (2) general allocations for classified loan pools, including special mention and substandard/accrual loans, as well as all remaining pools of loans. The Company accumulates pools based on the underlying classification of the collateral. Each pool is assigned a loss severity rate based on historical loss experience and various qualitative and environmental factors, including, but not limited to, credit quality and economic conditions. The Company determines the allowance on a quarterly basis. Because of uncertainties inherent in the estimation process, management’s estimate of credit losses in the loan portfolio and the related allowance may materially change in the near term. However, the amount of the change that is reasonably possible cannot be estimated.

Table of Contents

The following table presents an analysis of the activity in the allowance for loan and lease losses for the three and nine months ended September 30, 2013 and September 30, 2012. The provisions for loan and lease losses in the table below do not include the Company’s provision accrual for unfunded commitments of $6 thousand and $18 thousand for the three and nine months ended September 30, 2013 and September 30, 2012, respectively. The reserve for unfunded commitments is included in other liabilities in the consolidated balance sheets and totaled $276 thousand, $258 thousand and $252 thousand at September 30, 2013, December 31, 2012 and September 30, 2012, respectively.

Allowance for Loan and Lease Losses

For the Three Months Ended September 30, 2013



	Real estate: Residential 1-4 family			Real estate: Commercial			Real estate: Construction			Real estate: Multi-family and farmland			Commercial			Consumer			Leases			Other			Total
	(in thousands)

Beginning balance, June 30, 2013	$	5,167		$	3,516		$	1,230		$	1,128		$	1,071		$	159		$	9		$	20		$	12,300
Charge-offs	(256		)	(118		)	(34		)	(36		)	(4		)	(127		)	—			—			(575		)
Recoveries	46			248			182			5			14			64			46			2			607
Provision (Credit)	(723		)	(771		)	(30		)	(29		)	(61		)	37			(47		)	(8		)	(1,632		)
Ending balance, September 30, 2013	$	4,234		$	2,875		$	1,348		$	1,068		$	1,020		$	133		$	8		$	14		$	10,700

Allowance for Loan and Lease Losses

For the Nine Months Ended September 30, 2013



	Real estate: Residential 1-4 family			Real estate: Commercial			Real estate: Construction			Real estate: Multi-family and farmland			Commercial			Consumer			Leases			Other			Total
	(in thousands)

Beginning balance, December 31, 2012	$	6,207		$	3,736		$	667		$	741		$	2,103		$	272		$	47		$	27		$	13,800
Charge-offs	(1,324		)	(531		)	(503		)	(36		)	(31		)	(460		)	—			—			(2,885		)
Recoveries	281			313			312			15			218			289			133			4			1,565
Provision (Credit)	(930		)	(643		)	872			348			(1,270		)	32			(172		)	(17		)	(1,780		)
Ending balance, September 30, 2013	$	4,234		$	2,875		$	1,348		$	1,068		$	1,020		$	133		$	8		$	14		$	10,700

Table of Contents

Allowance for Loan and Lease Losses

For the Three Months Ended September 30, 2012



	Real estate: Residential 1-4 family			Real estate: Commercial			Real estate: Construction			Real estate: Multi-family and farmland			Commercial			Consumer			Leases			Other		Total
	(in thousands)
Beginning balance, June 30, 2012	$	6,064		$	5,137		$	1,668		$	1,592		$	4,633		$	359		$	125		$	22	$	19,600
Charge-offs	(644		)	(2,801		)	(2,334		)	(13		)	(2,388		)	(166		)	(1		)	—		(8,347		)
Recoveries	53			8			467			3			109			385			668			1		1,694
Provision (Credit)	1,321			2,319			1,256			58			473			(181		)	(705		)	2		4,543
Ending balance, September 30, 2012	$	6,794		$	4,663		$	1,057		$	1,640		$	2,827		$	397		$	87		$	25	$	17,490

Allowance for Loan and Lease Losses

For the Nine Months Ended September 30, 2012



	Real estate: Residential 1-4 family			Real estate: Commercial			Real estate: Construction			Real estate: Multi-family and farmland			Commercial			Consumer			Leases			Other			Total
	(in thousands)
Beginning balance, December 31, 2011	$	6,368		$	6,227		$	1,485		$	728		$	3,649		$	405		$	718		$	20		$	19,600
Charge-offs	(2,532		)	(3,930		)	(5,246		)	(28		)	(2,659		)	(304		)	(864		)	(3		)	(15,566		)
Recoveries	145			116			991			9			340			479			877			7			2,964
Provision (Credit)	2,813			2,250			3,827			931			1,497			(183		)	(644		)	1			10,492
Ending balance, September 30, 2012	$	6,794		$	4,663		$	1,057		$	1,640		$	2,827		$	397		$	87		$	25		$	17,490

Table of Contents

The following table presents an analysis of the end of period balance of the allowance for loan and lease losses as of September 30, 2013.

As of September 30, 2013



	Real estate: Residential 1-4 family				Real estate: Commercial				Real estate: Construction				Real estate: Multi-family and farmland				Total Real Estate Loans
	Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance
	(in thousands)
Individually evaluated	$	1,424	$	—	$	358	$	—	$	26	$	—	$	—	$	—	$	1,808	$	—
Collectively evaluated	172,022		4,234		222,245		2,875		42,338		1,348		18,844		1,068		455,449		9,525
Total evaluated	$	173,446	$	4,234	$	222,603	$	2,875	$	42,364	$	1,348	$	18,844	$	1,068	$	457,257	$	9,525



	Commercial				Consumer				Leases				Other				Grand Total
(continued from above)	Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance
	(in thousands)
Individually evaluated	$	756	$	—	$	—	$	—	$	—	$	—	$	—	$	—	$	2,564	$	—
Collectively evaluated	50,123		1,020		21,586		133		42		8		4,863		14		532,063		10,700
Total evaluated	$	50,879	$	1,020	$	21,586	$	133	$	42	$	8	$	4,863	$	14	$	534,627	$	10,700

The following table presents an analysis of the end of period balance of the allowance for loan and lease losses as of December 31, 2012.

As of December 31, 2012



	Real estate: Residential 1-4 family				Real estate: Commercial				Real estate: Construction				Real estate: Multi-family and farmland				Total Real Estate Loans
	Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance
	(in thousands)
Individually evaluated	$	457	$	—	$	727	$	—	$	1,783	$	—	$	—	$	—	$	2,967	$	—
Collectively evaluated	187,734		6,207		220,928		3,736		31,624		667		17,051		741		457,337		11,351
Total evaluated	$	188,191	$	6,207	$	221,655	$	3,736	$	33,407	$	667	$	17,051	$	741	$	460,304	$	11,351



	Commercial				Consumer				Leases				Other				Grand Total
(continued from above)	Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance
	(in thousands)
Individually evaluated	$	2,077	$	50	$	—	$	—	$	392	$	—	$	—	$	—	$	5,436	$	50
Collectively evaluated	59,321		2,053		13,387		272		176		47		5,473		27		535,694		13,750
Total evaluated	$	61,398	$	2,103	$	13,387	$	272	$	568	$	47	$	5,473	$	27	$	541,130	$	13,800

Table of Contents

The following table presents an analysis of the end of period balance of the allowance for loan and lease losses as of September 30, 2012.

As of September 30, 2012



	Real estate: Residential 1-4 family				Real estate: Commercial				Real estate: Construction				Real estate: Multi-family and farmland				Total Real Estate Loans
	Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance
	(in thousands)
Individually evaluated	$	4,214	$	82	$	9,183	$	16	$	4,091	$	—	$	805	$	—	$	18,293	$	98
Collectively evaluated	196,352		6,712		223,287		4,647		33,653		1,057		23,270		1,640		476,562		14,056
Total evaluated	$	200,566	$	6,794	$	232,470	$	4,663	$	37,744	$	1,057	$	24,075	$	1,640	$	494,855	$	14,154



	Commercial				Consumer				Leases				Other and Unallocated				Grand Total
(continued from above)	Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance		Carrying Value		Associated Allowance
	(in thousands)
Individually evaluated	$	1,297	$	—	$	—	$	—	$	422	$	—	$	—	$	—	$	20,012	$	98
Collectively evaluated	56,748		2,827		14,757		397		349		87		4,937		25		553,353		17,392
Total evaluated	$	58,045	$	2,827	$	14,757	$	397	$	771	$	87	$	4,937	$	25	$	573,365	$	17,490

The Company utilizes a risk rating system to evaluate the credit risk of its loan portfolio. The Company classifies loans as: pass, special mention, substandard/non-impaired, substandard/impaired, doubtful or loss. The following describes the Company's classifications and the various risk indicators associated with each rating.

A pass rating is assigned to those loans that are performing as contractually agreed and do not exhibit the characteristics of the criticized and classified risk ratings as defined below. Pass loan pools do not include the unfunded portions of binding commitments to lend, standby letters of credit, deposit secured loans or mortgage loans originated with commitments to sell in the secondary market. Loans secured by segregated deposits held by FSGBank are not required to have an allowance reserve, nor are originated held-for-sale mortgage loans pending sale in the secondary market.

A special mention loan risk rating is considered criticized but is not considered as severe as a classified loan risk rating. Special mention loans contain one or more potential weakness(es), which if not corrected, could result in an unacceptable increase in credit risk at some future date. These loans may be characterized by the following risks and/or trends:

Loans to Businesses:


•	Downward trend in sales, profit levels and margins


•	Impaired working capital position compared to industry


•	Cash flow strained in order to meet debt repayment schedule


•	Technical defaults due to noncompliance with financial covenants


•	Recurring trade payable slowness


•	High leverage compared to industry average with shrinking equity cushion


•	Questionable abilities of management


•	Weak industry conditions


•	Inadequate or outdated financial statements

Table of Contents

Loans to Businesses or Individuals:


•	Loan delinquencies and overdrafts may occur


•	Original source of repayment questionable


•	Documentation deficiencies may not be easily correctable


•	Loan may need to be restructured


•	Collateral or guarantor offers adequate protection


•	Unsecured debt to tangible net worth is excessive

The Company segregates substandard loans into two classifications based on the Company’s allowance methodology for impaired loans. The Company defines a substandard/impaired loan as a substandard loan relationship in excess of $500 thousand that is individually reviewed. Substandard loans have a greater likelihood of loss and may require a protracted work-out plan. In addition to the factors listed for special mention loans, substandard loans may be characterized by the following risks and/or trends:

Loans to Businesses:


•	Sustained losses that have severely eroded equity and cash flows


•	Concentration in illiquid assets


•	Serious management problems or internal fraud


•	Chronic trade payable slowness; may be placed on COD or collection by trade creditor


•	Inability to access other funding sources


•	Financial statements with adverse opinion or disclaimer; may be received late


•	Insufficient documented cash flows to meet contractual debt service requirements

Loans to Businesses or Individuals:


•	Chronic or severe delinquency or has met the retail classification standards which is generally past dues greater than 90 days


•	Frequent overdrafts


•	Likelihood of bankruptcy exists


•	Serious documentation deficiencies


•	Reliance on secondary sources of repayment which are presently considered adequate


•	Demand letter sent


•	Litigation may have been filed against the borrower

Loans with a risk rating of doubtful are individually analyzed to determine the Company's best estimate of the loss based on the most recent assessment of all available sources of repayment. Doubtful loans are considered impaired and placed on nonaccrual. For doubtful loans, the collection or liquidation in full of principal and/or interest is highly questionable or improbable. The Company estimates the specific potential loss based upon an individual analysis of the relationship risks, the borrower’s cash flow, the borrower’s management and any underlying secondary sources of repayment. The amount of the estimated loss, if any, is then either specifically reserved in a separate component of the allowance or charged-off. In addition to the characteristics listed for substandard loans, the following characteristics apply to doubtful loans:

Loans to Businesses:


•	Normal operations are severely diminished or have ceased


•	Seriously impaired cash flow


•	Numerous exceptions to loan agreement


•	Outside accountant questions entity’s survivability as a “going concern”


•	Financial statements may be received late, if at all


•	Material legal judgments filed


•	Collection of principal and interest is impaired


•	Collateral/Guarantor may offer inadequate protection

Loans to Businesses or Individuals:


•	Original repayment terms materially altered


•	Secondary source of repayment is inadequate


•	Asset liquidation may be in process with all efforts directed at debt retirement


•	Documentation deficiencies not correctable

Table of Contents

The consistent application of the above loan risk rating methodology ensures that the Company has the ability to track historical losses and appropriately estimate potential future losses in our allowance. Additionally, appropriate loan risk ratings assist the Company in allocating credit and special asset personnel in the most effective manner. Significant changes in loan risk ratings can have a material impact on the allowance and thus a material impact on the Company's financial results by requiring significant increases or decreases in provision expense. The Company individually reviews these relationships on a quarterly basis to determine the required allowance or loss, as applicable.

The following table presents the Company’s internal risk rating by loan classification as utilized in the allowance analysis as of September 30, 2013:

As of September 30, 2013



	Pass		Special Mention		Substandard – Non-impaired		Substandard – Impaired		Total
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	152,115	$	9,182	$	10,725	$	1,424	$	173,446
Real estate: Commercial	207,015		5,206		10,024		358		222,603
Real estate: Construction	37,723		83		4,532		26		42,364
Real estate: Multi-family and farmland	16,947		999		898		—		18,844
Commercial	44,572		2,868		2,683		756		50,879
Consumer	21,228		79		279		—		21,586
Leases	—		—		42		—		42
Other	4,810		—		53		—		4,863
Total Loans	$	484,410	$	18,417	$	29,236	$	2,564	$	534,627

The following table presents the Company’s internal risk rating by loan classification as utilized in the allowance analysis as of December 31, 2012:



As of December 31, 2012
	Pass		Special Mention		Substandard – Non-impaired		Substandard – Impaired		Total
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	164,555	$	7,668	$	15,511	$	457	$	188,191
Real estate: Commercial	207,188		4,930		8,810		727		221,655
Real estate: Construction	30,471		97		1,056		1,783		33,407
Real estate: Multi-family and farmland	14,025		1,794		1,232		—		17,051
Commercial	51,972		756		6,593		2,077		61,398
Consumer	12,793		126		468		—		13,387
Leases	1		74		101		392		568
Other	5,365		—		108		—		5,473
Total Loans	$	486,370	$	15,445	$	33,879	$	5,436	$	541,130

Table of Contents

The following table presents the Company’s internal risk rating by loan classification as utilized in the allowance analysis as of September 30, 2012:



As of September 30, 2012
	Pass		Special Mention		Substandard – Non-impaired		Substandard – Impaired		Total
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	169,964	$	7,355	$	19,033	$	4,214	$	200,566
Real estate: Commercial	205,863		3,319		14,105		9,183		232,470
Real estate: Construction	30,750		108		2,795		4,091		37,744
Real estate: Multi-family and farmland	14,233		2,180		6,857		805		24,075
Commercial	43,690		857		12,201		1,297		58,045
Consumer	14,136		80		541		—		14,757
Leases	—		196		153		422		771
Other	4,828		—		109		—		4,937
Total Loans	$	483,464	$	14,095	$	55,794	$	20,012	$	573,365

The Company classifies a loan as impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans were $2.6 million, $5.4 million and $20.0 million at September 30, 2013, December 31, 2012 and September 30, 2012, respectively. For impaired loans, the Company generally applies all payments directly to principal. Accordingly, the Company did not recognize any significant amount of interest income for impaired loans during the three and nine months ended September 30, 2013 and 2012.

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The following table presents additional information on the Company’s impaired loans as of September 30, 2013, December 31, 2012 and September 30, 2012:



	As of September 30, 2013								As of December 31, 2012
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Balance of Recorded Investment		Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Balance of Recorded Investment
	(in thousands)
Impaired loans with no related allowance recorded:
Real estate: Residential 1-4 family	$	1,424	$	1,641	$	—	$	2,815	$	457	$	529	$	—	$	3,474
Real estate: Commercial	358		393		—		5,795		727		4,438		—		10,099
Real estate: Construction	26		472		—		4,635		1,783		2,512		—		9,875
Real estate: Multi-family and farmland	—		—		—		685		—		—		—		1,071
Commercial	756		1,894		—		1,911		2,027		3,062		—		2,214
Consumer	—		—		—		50		—		—		—		385
Leases	—		—		—		367		392		392		—		684
Total	$	2,564	$	4,400	$	—	$	16,258	$	5,386	$	10,933	$	—	27,802
Impaired loans with an allowance recorded:
Real estate: Residential 1-4 family	$	—	$	—	$	—	$	306	$	—	$	—	$	—	425
Real estate: Commercial	—		—		—		334		—		—		—		445
Real estate: Construction	—		—		—		1,167		—		—		—		2,214
Real estate: Multi-family and farmland	—		—		—		71		—		—		—		71
Commercial	—		—		—		360		50		95		50		1,074
Consumer	—		—		—		—		—		—		—		96
Leases	—		—		—		—		—		—		—		108
Total	—		—		—		2,238		50		95		50		4,433
Total impaired loans	$	2,564	$	4,400	$	—	$	18,496	$	5,436	$	11,028	$	50	32,235

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	As of September 30, 2012
	Recorded Investment		Unpaid Principal Balance		Related Allowance		Average Balance of Recorded Investment
	(in thousands)
Impaired loans with no related allowance recorded:
Real estate: Residential 1-4 family	$	3,910	$	4,355	$	—	$	3,529
Real estate: Commercial	8,699		14,167		—		10,639
Real estate: Construction	4,091		9,761		—		9,383
Real estate: Multi-family and farmland	805		909		—		859
Commercial	1,297		2,523		—		1,975
Consumer	—		—		—		418
Leases	422		422		—		616
Other	—		—		—		—
Total	$	19,224	$	32,137	$	—	$	27,419
Impaired loans with an allowance recorded:
Real estate: Residential 1-4 family	$	304	$	332	$	82	$	359
Real estate: Commercial	484		484		16		381
Real estate: Construction	—		—		—		1,945
Real estate: Multi-family and farmland	—		—		—		89
Commercial	—		—		—		1,330
Consumer	—		—		—		—
Leases	—		—		—		135
Total	788		816		98		4,239
Total impaired loans	$	20,012	$	32,953	$	98	$	31,658

Nonaccrual loans were $6.8 million, $11.7 million and $32.3 million at September 30, 2013, December 31, 2012 and September 30, 2012, respectively. The following table provides nonaccrual loans by type:



	As of September 30, 2013		As of December 31, 2012		As of September 30, 2012
	(in thousands)
Nonaccrual Loans by Classification
Real estate: Residential 1-4 family	$	3,464	$	3,906	$	10,269
Real estate: Commercial	939		1,814		11,513
Real estate: Construction	461		2,549		5,579
Real estate: Multi-family and farmland	57		94		1,314
Commercial	1,605		2,524		2,654
Consumer and other	257		375		429
Leases	20		436		496
Total Loans	$	6,803	$	11,698	$	32,254

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The Company monitors loans by past due status. The following table provides the past due status for all loans. Nonaccrual loans are included in the applicable classification.



As of September 30, 2013
	30-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total		Greater than 90 Days Past Due and Accruing
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	2,761	$	2,328	$	5,089	$	168,357	$	173,446	$	496
Real estate: Commercial	780		1,419		2,199		220,404		222,603		—
Real estate: Construction	37		496		533		41,831		42,364		—
Real estate: Multi-family and farmland	—		119		119		18,725		18,844		13
Subtotal of real estate secured loans	3,578		4,362		7,940		449,317		457,257		509
Commercial	120		1,303		1,423		49,456		50,879		—
Consumer	9		250		259		21,327		21,586		—
Leases	—		42		42		—		42		—
Other	—		—		—		4,863		4,863		—
Total Loans	$	3,707	$	5,957	$	9,664	$	524,963	$	534,627	$	509



As of December 31, 2012
	30-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total		Greater than 90 Days Past Due and Accruing
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	3,189	$	3,066	$	6,255	$	181,936	$	188,191	$	312
Real estate: Commercial	885		1,973		2,858		218,797		221,655		159
Real estate: Construction	626		1,653		2,279		31,128		33,407		—
Real estate: Multi-family and farmland	255		89		344		16,707		17,051		—
Subtotal of real estate secured loans	4,955		6,781		11,736		448,568		460,304		471
Commercial	1,223		2,360		3,583		57,815		61,398		463
Consumer	107		270		377		13,010		13,387		—
Leases	28		435		463		105		568		4
Other	—		—		—		5,473		5,473		—
Total Loans	$	6,313	$	9,846	$	16,159	$	524,971	$	541,130	$	938

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As of September 30, 2012
	30-89 Days Past Due		Greater than 90 Days Past Due		Total Past Due		Current		Total		Greater than 90 Days Past Due and Accruing
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	3,462	$	8,356	$	11,818	$	188,748	$	200,566	$	1,592
Real estate: Commercial	4,451		9,321		13,772		218,698		232,470		577
Real estate: Construction	49		5,584		5,633		32,111		37,744		182
Real estate: Multi-family and farmland	1,266		798		2,064		22,011		24,075		187
Subtotal of real estate secured loans	9,228		24,059		33,287		461,568		494,855		2,538
Commercial	962		2,644		3,606		54,439		58,045		34
Consumer	28		294		322		14,435		14,757		—
Leases	87		481		568		203		771		—
Other	—		—		—		4,937		4,937		—
Total Loans	$	10,305	$	27,478	$	37,783	$	535,582	$	573,365	$	2,572

As of September 30, 2013, the Company had four loans, not on non-accrual, that were considered troubled debt restructurings. One commercial loan of $629 thousand was restructured to an extended term to assist the borrower by reducing the monthly payments. Two residential loans of $283 thousand were restructured with lower interest rates and payments and one consumer loan of $22 thousand was restructured with lower payments. As of September 30, 2013, these loans are performing under the modified terms.

The Company had $1.0 million and $1.8 million in troubled debt restructurings outstanding as of September 30, 2013 and 2012, respectively. The Company has allocated no specific reserves to customers whose loan terms have been modified in troubled debt restructurings as of September 30, 2013 and September 30, 2012. The Company has not committed to lend additional amounts as of September 30, 2013 and 2012 to customers with outstanding loans that are classified as troubled debt restructurings.

The Company completed one modification totaling $22 thousand that would qualify as a troubled debt restructuring during the three months ended September 30, 2013. The company completed two modifications totaling $227 thousand that would qualify as a troubled debt restructuring for the three and nine months ended September 30, 2012. The Company completed three modifications totaling $121 thousand that would qualify as a troubled debt restructuring during the nine months ended September 30, 2013.

The following table presents loans by class modified as troubled debt restructurings for which there was a payment default within twelve months following the modification during the three and nine months ended September 30, 2013 and 2012:



	Three Months Ended					Three Months Ended
	September 30, 2013					September 30, 2012
	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
		(dollar amounts in thousands)					(dollar amounts in thousands)
Troubled Debt Restructurings That Subsequently Defaulted:
Real estate:
Residential	—	$	—	$	—	1	$	235	$	—
Commercial	—	—		—		2	1,352		794
Total	—	$	—	$	—	3	$	1,587	$	794

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	Nine Months Ended					Nine Months Ended
	September 30, 2013					September 30, 2012
	Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment		Number of Contracts	Pre-Modification Outstanding Recorded Investment		Post-Modification Outstanding Recorded Investment
		(dollar amounts in thousands)					(dollar amounts in thousands)
Troubled Debt Restructurings That Subsequently Defaulted:
Real estate:
Residential	1	$	70	$	70	1	$	235	$	—
Commercial	—	—		—		2	1,352		794
Total	1	$	70	$	70	3	$	1,587	$	794

A loan is considered to be in payment default once it is 30 days contractually past due under the modified terms.

The troubled debt restructurings that subsequently defaulted described above increased the allowance for loan losses and resulted in zero charge offs during the three and nine months ended September 30, 2013, and zero and $828 thousand in charge offs during the three and nine months ended September 30, 2012, respectively.

NOTE 9 – SUPPLEMENTAL FINANCIAL DATA

Components of other noninterest income or other noninterest expense in excess of 1% of the aggregate of total interest income and noninterest income are shown in the following table.



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2013		2012		2013		2012
Other noninterest income—	(in thousands)
Point-of-service fees	401		339		1,171		1,033
Bank-owned life insurance income	237		352		720		778
Trust fees	193		122		527		392
Gain on sale of other real estate owned	187		497		640		798
All other items	278		267		818		966
Total other noninterest income	$	1,296	$	1,577	$	3,876	$	3,967
Other noninterest expense—
Professional fees	$	839	$	796	$	3,823	$	2,641
FDIC insurance	150		750		2,150		2,077
Data processing	305		728		978		1,571
Write-downs on other real estate owned and repossessions	374		1,314		1,997		4,500
Losses on other real estate owned, repossessions and fixed assets	46		120		206		749
Non-performing asset expenses	165		503		1,440		1,516
Communications	121		129		331		375
ATM/Debit Card fees	144		138		476		376
Insurance	523		426		1,873		1,038
OCC Assessments	125		127		376		377
Intangible asset amortization	67		93		213		305
All other items	1,207		932		3,126		2,512
Total other noninterest expense	$	4,066	$	6,056	$	16,989	$	18,037

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NOTE 10 – COMMITMENTS AND CONTINGENCIES

The Company is party to credit related 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 the issuance of financial guarantees in the form of financial and performance standby letters of credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.

The Company’s exposure to credit loss is represented by the contractual amount of these commitments. The Company follows the same credit policies in making commitments as they do for on-balance-sheet instruments.

The Company’s maximum exposure to credit risk for unfunded loan commitments and standby letters of credit at September 30, 2013, December 31, 2012 and September 30, 2012 was as follows:



	September 30, 2013		December 31, 2012		September 30, 2012
	(in thousands)
Commitments to extend credit - fixed rate	$	29,464	$	16,312	$	20,430
Commitments to extend credit - variable rate	$	90,086	$	94,822	$	81,722
Total commitments to extend credit	$	119,550	$	111,134	$	102,152

Standby letters of credit	$	3,308	$	5,023	$	4,867

Commitments to extend credit are agreements to lend to customers. Standby letters of credit are contingent commitments issued by the Company to guarantee performance of a customer to a third party under a contractual non-financial obligation for which it receives a fee. Financial standby letters of credit represent a commitment to guarantee customer repayment of an outstanding loan or debt instrument. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. 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 on extension of credit, is based on management’s credit evaluation. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.

The Company is subject to various legal proceedings and claims that arise in the ordinary course of its business. Additionally, in the ordinary course of business, the Company is subject to regulatory examinations, information gathering requests, inquiries, and investigations. The Company establishes accruals for litigation and regulatory matters when those matters present loss contingencies that the Company determines to be both probable and reasonably estimable. Based on current knowledge, advice of counsel and available insurance coverage, management does not believe that liabilities arising from legal claims, if any, will have a material adverse effect on the Company’s consolidated financial condition, results of operations, or cash flows. However, in light of the significant uncertainties involved in these matters, the early stage of various legal proceedings, and the indeterminate amount of damages sought in some of these matters, it is possible that the ultimate resolution of these matters, if unfavorable, could be material to the Company’s results of operations for any particular period.

The Company intends to vigorously pursue all available defenses to these claims. There are significant uncertainties involved in any litigation. Although the ultimate outcome of these lawsuits cannot be ascertained at this time, based upon information that presently is available to it, management is unable to predict the outcome of these cases and cannot determine the probability of an adverse result or reasonably estimate a range of potential loss, if any. In addition, management is unable to estimate a range of reasonably possible losses with respect to these claims.

NOTE 11 – SHAREHOLDERS’ EQUITY

Preferred Stock Restructuring

On April 11, 2013, the Company completed a restructuring of the Company's Preferred Stock with the Treasury by issuing 9.9 million shares, or $14.9 million of new common stock for $1.50 per share for the full satisfaction of the Treasury's 2009 investment in the Company. Pursuant to the Exchange Agreement, as previously included in a Current Report on Form 8-K filed on February 26, 2013, the Company restructured the Company's Preferred Stock issued under the Capital Purchase Program by issuing new shares of common stock equal to 26.75% of the $33 million value of the Preferred Stock plus 100% of the accrued but unpaid dividends in exchange for the Preferred Stock, all accrued but unpaid dividends thereon, and the cancellation of stock warrants granted in connection with the CPP investment ("CPP Restructuring"). Immediately after the issuance of the common stock to the Treasury, the Treasury sold all of the Company's common stock to investors previously identified by the Company at the same $1.50 per share price.

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The Company recognized a $26.2 million credit to retained earnings for the nine months ended September 30, 2013, for the difference between the carrying amount of preferred stock and the amount paid to redeem the shares. The net increase to shareholders' equity as a result of the CPP Restructuring was $6.1 million.

Recapitalization

On April 12, 2013, the Company completed the issuance of an additional 50.8 million shares of new common stock, or $76.2 million, in a private placement to accredited investors. The private placement was previously announced on a Current Report on Form 8-K filed on February 26, 2013, in which the Company announced the execution of definitive stock purchase agreements with institutional investors as part of an approximately $90 million recapitalization ("Recapitalization"). In total, the Company issued 60,735,000 shares of common stock at $1.50 per share for gross proceeds of $91.1 million.

Common Stock Rights Offering

As part of the Recapitalization, the Company initiated a rights offering during the third quarter of 2013 for shareholders of record as of April 10, 2013, the business day immediately preceding the Recapitalization. The Rights Offering was previously announced on a Current Report on Form 8-K filed on February 26, 2013. Under the Rights Offering each Legacy Shareholder received one non-transferable subscription right to purchase two shares of the Company's common stock at the subscription price of $1.50 per share for every one share of common stock owned by such Legacy Shareholder as of the record date of April 10, 2013. Additionally, each Legacy Shareholder that fully exercised such Legacy Shareholder's subscription rights had the ability to submit an over-subscription request to purchase additional shares of common stock, subject to certain limitations and subject to allotment under the Rights Offering. On September 27, 2013, the Company completed the Rights Offering issuing 3,329,234 shares of common stock for $1.50 per share for gross proceeds of approximately $5.0 million. The Company downstreamed the net proceeds to supplement the capital of FSGBank.

Common Stock Dividends

On September 7, 2010, the Company entered into the Agreement with the Federal Reserve. Pursuant to the Agreement, the Company is prohibited from declaring or paying dividends without prior written consent from the Federal Reserve. See Note 2 for additional information regarding the Agreement.

Preferred Stock

Prior to the CPP Restructuring, the Company's Preferred Stock qualified as Tier 1 capital and paid cumulative dividends at a rate of 5% per annum. Dividends were payable quarterly on February 15, May 15, August 15 and November 15 of each year. The Company recognized zero and $929 thousand in dividends for the Preferred Stock for the three and nine months ended ended September 30, 2013, respectively, compared to $413 thousand and $1.2 million for the three and nine months ended September 30, 2012, respectively. For the three months ended September 30, 2013 and 2012, the Company recognized zero and $108 thousand, respectively, in discount accretion on the Preferred Stock. For the nine months ended September 30, 2013 and 2012, the Company recognized $452 thousand and $318 thousand, respectively, in discount accretion on the Preferred Stock.

NOTE 12 – INCOME TAXES

The Company accounts for income taxes in accordance with ASC 740, which requires an asset and liability approach for the financial accounting and reporting of income taxes. Under this method, deferred income taxes are recognized for the expected future tax consequences of differences between the tax bases of assets and liabilities and their reported amounts in the consolidated financial statements. These balances are measured using the enacted tax rates expected to apply in the year(s) in which these temporary differences are expected to reverse. The effect on deferred income taxes of a change in tax rates is recognized in income in the period when the change is enacted.

In accordance with ASC 740, the Company is required to establish a valuation allowance for deferred tax assets when it is “more likely than not” that a portion or all of the deferred tax assets will not be realized. The evaluation requires significant judgment and extensive analysis of all available positive and negative evidence, the forecasts of future income, applicable tax planning strategies and assessments of the current and future economic and business conditions.

During 2010, the Company established a deferred tax asset valuation allowance after evaluating all available positive and negative evidence. The Company evaluates the valuation allowance quarterly. Positive evidence includes the existence of taxes paid in available carryback years. Negative evidence includes a cumulative loss in recent years and general business and economic trends. As business and economic conditions change, the Company will re-evaluate the valuation allowance. As of September 30, 2013, the valuation allowance totals $58.0 million resulting in a net deferred tax asset of zero.

On October 24, 2012, the Board of Directors of the Company authorized the adoption by the Company of a Tax Benefits Preservation Plan and declared a dividend of one preferred stock purchase right for each outstanding share of the Company's

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common stock, payable to holders of record as of the close of business on November 12, 2012. The purpose of the Tax Benefits Preservation Plan is to assist preserving the value of the Company's deferred tax assets, such as its net operating losses, for U.S. federal income tax purposes. On July 24, 2013, the shareholders of the Company approved an amendment to the Company's articles of incorporation to further assist in preserving the value of the Company's deferred tax assets.

For the three and nine months ended September 30, 2013, the Company recognized an income tax provision of $322 thousand and $358 thousand, respectively. For the three and nine months ended September 30, 2012, the Company recognized an income tax provision of $108 thousand and an income tax benefit of $402 thousand, respectively. The following reconciles the income tax provision to Federal taxes at the statutory rate:



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013			2012			2013			2012
	(in thousands)
Federal taxes at statutory tax rate	$	(377	)	$	(2,985	)	$	(4,231	)	$	(7,614	)
Tax exempt earnings on loans and securities	(106		)	(77		)	(255		)	(265		)
Tax exempt earnings on bank owned life insurance	(57		)	(120		)	(176		)	(265		)
Low-income housing tax credits	(83		)	(91		)	(250		)	(272		)
Other, net	16			68			43			124
State tax provision, net of federal effect	(63		)	(366		)	(566		)	(937		)
Change in reserve for uncertain tax positions	—			—			—			(727		)
Changes in the deferred tax asset valuation allowance	992			3,679			5,793			9,554
Income tax provision (benefit)	$	322		$	108		$	358		$	(402	)

The increases in the deferred tax valuation allowance offset the income tax benefits and provision recognized for the three and nine months ended September 30, 2013. The benefit recognized before the valuation allowance primarily related to the year-to-date operating loss.

The Company evaluated its material tax positions as of September 30, 2013. Under the “more-likely-than-not” threshold guidelines, the Company believes it has identified all significant uncertain tax benefits. The Company evaluates, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant uncertain tax position is determined to exist, penalty and interest will be accrued, in accordance with Internal Revenue Service guidelines, and recorded as a component of income tax expense in the Company’s consolidated financial statements.

NOTE 13 – FAIR VALUE MEASUREMENTS

The authoritative accounting guidance for fair value measurements defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. A fair value measurement assumes that the transaction to sell the asset or transfer the liability occurs in the principal market for the asset or liability or, in the absence of a principal market, the most advantageous market for the asset or liability. Authoritative guidance establishes a fair value hierarchy for valuation inputs that gives the highest priority to quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs.

There are three levels of inputs that may be used to measure fair values:

Level 1 - Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity can access as of the measurement date.

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

Level 3 - Significant unobservable inputs that reflect a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of September 30, 2013, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly. Level 2 inputs include quoted prices for similar assets or liabilities in active markets, and inputs other than quoted

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prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the hierarchy. In such cases, the fair value is determined based on the lowest level input that is significant to the fair value measurement in its entirety.

The Company used the following methods and significant assumptions to estimate fair value:

Cash and cash equivalents: The carrying value of cash and cash equivalents approximates fair value.

Interest bearing deposits in banks: The carrying amounts of interest bearing deposits in banks approximate fair value.

Federal Home Loan Bank Stock and Federal Reserve Bank Stock: It is not practical to determine the fair value of FHLB stock or FRB Stock due to restrictions placed on their transferability. As such, these instruments are carried at cost.

Securities: The fair values for investment securities are determined by quoted market prices, if available (Level 1). For securities where quoted prices are not available, fair values are calculated based on market prices of similar securities (Level 2). For securities where quoted prices or market prices of similar securities are not available, fair values are calculated using discounted cash flows or other market indicators (Level 3). Discounted cash flows are calculated using spread to swap and LIBOR curves that are updated to incorporate loss severities, volatility, credit spread and optionality. During times when trading is more liquid, broker quotes are used (if available) to validate the model. Rating agency and industry research reports as well as defaults and deferrals on individual securities are reviewed and incorporated into the calculations. Our municipal securities valuations are supported by analysis prepared by an independent third party. Their approach to determining fair value involves using recently executed transactions for similar securities and market quotations for similar securities. As these securities are not rated by the rating agencies and trading volumes are thin, it was determined that these were valued using Level 2 inputs.

Derivatives: The fair values of derivatives are based on valuation models using observable market data as of the measurement date (Level 2).

Loans: For variable-rate loans that reprice frequently and have no significant changes in credit risk, fair values are based on carrying values. Fair values for certain mortgage loans and other consumer loans are 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 and leases is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers of similar credit ratings quality. Fair value for impaired loans and leases are estimated using discounted cash flow analysis or underlying collateral values, where applicable. The fair value may not approximate the exit price.

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

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

Appraisals for both collateral-dependent impaired loans and other real estate owned are performed annually by certified general appraisers (for commercial properties) or certified residential appraisers (for residential properties) whose qualifications and licenses have been reviewed and verified by the Company. Once received, a member of the Special Assets Department reviews the assumptions and approaches utilized in the appraisal as well as the overall resulting fair value in comparison with via independent data sources such as recent market data or industry-wide statistics. On an annual basis, the Company compares the actual selling price of collateral that has been sold to the most recent appraised value to determine what additional

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adjustment should be made to the appraisal value to arrive at fair value. The most recent analysis performed indicated that a discount of approximately 17% should be applied.

Loans Held For Sale: Fair value for loans originated to be held for sale is determined using quoted prices for similar assets, adjusted for specific attributes of that loan or other observable market data, such as outstanding commitments from third party investors (Level 2). Fair value of loans transferred to held for sale is determined using the sales price of the loans which has no observable market, resulting in a Level 3 fair value classification.

Accrued interest receivable: The carrying value of accrued interest receivable approximates fair value.

Deposit liabilities: The fair value of demand deposits, savings accounts, and certain money market deposits is the amount payable on demand at the reporting date. The fair value for fixed-rate certificates of deposit is estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregate expected maturities on time deposits.

Federal funds purchased and securities sold under agreements to repurchase: These borrowings generally mature in 90 days or less and, accordingly, the carrying amount reported in the consolidated balance sheets approximates fair value.

Accrued interest payable: The carrying value of accrued interest payable approximates fair value.

Other borrowings: Other borrowings carrying amount reported in the consolidated balance sheets approximates fair value.

Assets and liabilities measured at fair value on a recurring basis, including financial assets and liabilities for which the Company has elected the fair value option, are summarized below:



	Fair Value Measurements at
	September 30, 2013 Using:
	Level 1		Level 2		Level 3		Total
	(in thousands)
Financial assets
Securities available-for-sale—
Federal Agencies	$	—	$	6,134	$	—	$	6,134
Mortgage-backed—residential	—		146,428		—		146,428
Municipals	—		33,380		—		33,380
Other	—		21,012		55		21,067
Total securities available-for-sale	$	—	$	206,954	$	55	$	207,009
Loans held for sale	$	—	$	1,661	$	—	$	1,661
Zero premium collar	$	—	$	33	$	—	$	33
Financial liabilities
Forward loan sales contracts	$	—	$	49	$	—	$	49
Cash flow swap	$	—	$	33	$	—	$	33

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	Fair Value Measurements at
	December 31, 2012 Using:
	Level 1		Level 2		Level 3		Total
	(in thousands)
Financial assets
Securities available-for-sale—
Federal agencies	$	—	$	57,545	$	—	$	57,545
Mortgage-backed—residential	—		160,477		—		160,477
Municipals	—		35,994		—		35,994
Other	—		—		41		41
Total securities available-for-sale	$	—	$	254,016	$	41	$	254,057
Loans held for sale	$	—	$	3,624	$	—	$	3,624
Financial liabilities
Forward loan sales contracts	$	—	$	25	$	—	$	25



	Fair Value Measurements at
	September 30, 2012 Using:
	Level 1		Level 2		Level 3		Total
	(in thousands)
Financial assets
Securities available-for-sale—
Federal agencies	$	—	$	32,447	$	—	$	32,447
Mortgage-backed—residential	—		194,665		—		194,665
Municipals	—		29,523		586		30,109
Other	—		—		42		42
Total securities available-for-sale	$	—	$	256,635	$	628	$	257,263
Loans held for sale	$	—	$	3,857	$	—	$	3,857
Financial liabilities
Forward loan sales contracts	$	—	$	139	$	—	$	139

The following table presents additional information about changes in assets and liabilities measured at fair value on a recurring basis and for which the Company utilized Level 3 inputs to determine fair value as of September 30, 2013 and 2012.

September 30, 2013



	Balance as of December 31, 2012		Total Realized and Unrealized Gains or Losses	Sales	Net Transfers In and/or Out of Level 3	Balance as of September 30, 2013
	(in thousands)
Financial assets
Securities available-for-sale—
Other	$	41	14	—	—	$	55

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September 30, 2012



	Balance as of December 31, 2011		Total Realized and Unrealized Gains or Losses		Sales		Net Transfers In and/or Out of Level 3	Balance as of September 30, 2012
	(in thousands)
Financial assets
Securities available-for-sale—
Municipals	$	1,339	(18	)	(735	)	—	$	586
Other	$	36	33		(27	)	—	$	42

At September 30, 2013, the Company also had assets and liabilities measured at fair value on a non-recurring basis. Items measured at fair value on a non-recurring basis include other real estate owned (OREO), and collateral-dependent impaired loans. Such measurements were determined utilizing Level 3 inputs.

The following table presents the carrying value and associated valuation allowance of those assets measured at fair value on a non-recurring basis for which impairment was recognized during the nine months ended September 30, 2013.



	Carrying Value as of September 30, 2013		Level 1 Fair Value Measurement		Level 2 Fair Value Measurement		Level 3 Fair Value Measurement		Valuation Allowance as of September 30, 2013
	(in thousands)
Other real estate owned –
Construction/development loans	$	3,860	$	—	$	—	$	3,860	$	(3,914	)
Residential real estate loans	1,555		—		—		1,555		(570		)
Multi-family and farmland	381		—		—		381		(263		)
Commercial real estate loans	2,519		—		—		2,519		(1,930		)
Commercial and industrial loans	347		—		—		347		(150		)
Other real estate owned	8,662		—		—		8,662		(6,827		)
Collateral-dependent loans –
Real Estate: Residential 1-4 family	1,102		—		—		1,102		—
Real Estate: Commercial	358		—		—		358		—
Real Estate: Construction	26		—		—		26		—
Commercial	436		—		—		436		—
Collateral-dependent loans	1,922		—		—		1,922		—
Totals	$	10,584	$	—	$	—	$	10,584	$	(6,827	)

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	Carrying Value as of December 31, 2012		Level 1 Fair Value Measurement		Level 2 Fair Value Measurement		Level 3 Fair Value Measurement		Valuation Allowance as of December 31, 2012
	(in thousands)
Loans transferred to held for sale	$	22,296	$	—	$	—	$	22,296	$	—
Other real estate owned –
Construction/development loans	5,279		—		—		5,279		(2,921		)
Residential real estate loans	1,489		—		—		1,489		(450		)
Commercial real estate loans	2,901		—		—		2,901		(1,081		)
Multi-family and farmland loans	873		—		—		873		(229		)
Commercial and industrial loans	273		—		—		273		(150		)
Other real estate owned	10,815		—		—		10,815		(4,831		)
Collateral-dependent loans –
Real Estate: Residential 1-4 family	457		—		—		457		—
Real Estate: Commercial	727		—		—		727		—
Real Estate: Construction	1,783		—		—		1,783		—
Commercial	436		—		—		436		—
Collateral-dependent loans	3,403		—		—		3,403		—
Totals	$	14,218	$	—	$	—	$	14,218	$	(4,831	)

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	Carrying Value as of September 30, 2012		Level 1 Fair Value Measurement		Level 2 Fair Value Measurement		Level 3 Fair Value Measurement		Valuation Allowance as of September 30, 2012
	(in thousands)
Other real estate owned -
Construction/development loans	$	5,644	$	—	$	—	$	5,644	$	(1,374	)
Residential real estate loans	2,104		—		—		2,104		(266		)
Multi-family and farmland loans	972		—		—		972		(131		)
Commercial real estate loans	4,539		—		—		4,539		(1,124		)
Other real estate owned	13,259		—		—		13,259		(2,895		)

Collateral-dependent loans -
Real Estate: Residential 1-4 family	3,496		—		—		3,496		(74		)
Real Estate: Commercial	8,109		—		—		8,109		(16		)
Real Estate: Construction	2,774		—		—		2,774		—
Real Estate: Multi-family and farmland	339		—		—		339		—
Commercial	2,829		—		—		2,829		—
Collateral-dependent loans	17,547		—		—		17,547		(90		)
Totals	$	30,806	$	—	$	—	$	30,806	$	(2,985	)

For the nine month period ended September 30, 2013, the Company established, increased or decreased its valuation allowance on $8.7 million of other real estate owned. The Company recorded write-downs on other real estate owned of $374 thousand and $2.0 million during the three and nine months ended September 30, 2013, respectively, and $1.3 million and $4.5 million during the three and nine months ended September 30, 2012, respectively. For collateral-dependent loans, no provision for loan loss was recorded during the three and nine months ended September 30, 2013, as compared to $337 thousand and $4.9 million for the same periods in the prior year. Any changes in the valuation allowance for a collateral-dependent loan are included in the allowance analysis and may result in additional provision expense.

There have been no transfers into or out of Level 3 during 2013 or 2012. There were no transfers between Level 1 and Level 2 during 2013 or 2012.

For impaired loans and OREO properties, the Company utilizes independent, third-party appraisals to determine fair value. Independent appraisals are ordered at least annually. As part of the normal appraisal process, the appraisers generally provide the appraised value using one of following techniques: the sales comparison approach, the income approach or a combination thereof. Under the sales comparison approach, the appraiser may make certain adjustments from the sold property to the appraised property, including, but not limited to, differences in square footage, lot size, absorption rates or location. As of September 30, 2013, the adjustments between the appraised property and the comparison property range from (75.8)% to 102.9% with a weighted average adjustment of 0.18%. Under the income approach, the appraiser may make certain adjustments including, but not limited to, capitalization rates and differences in operating income expectations. The Company's current third-party appraisals provided capitalization rates up to 11.0% with a weighted average of 7.12%. The Company's current third-party appraisals do not provide a range of adjustments to net operating income expectations. The Company monitors the realization rate between proceeds received and appraised value for all sold OREO properties. This discount, defined as the weighted average percentage difference between appraised values and proceeds, is then applied to all remaining appraisals associated with impaired loans and OREO properties. The Company monitors and applies this adjustment to the Company's Level 3 properties. The weighted average discount is approximately 17% as of September 30, 2013.

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The following table presents quantitative information about Level 3 fair value measurements for significant financial instruments measured at fair value on a non-recurring basis at September 30, 2013.



	Fair value (in thousands)		Valuation technique(s)	Unobservable input(s)	Range				Weighted average
Impaired Loans - CRE	$	358	Sales comparison approach	Adjustment for differences between the comparable sales	(70.0	)%	210.1	%	(14.3	)%
			Income Approach	Capitalization rate	9.0	%	12.5	%	10.1	%
Impaired Loans - Residential	1,102		Sales comparison approach	Adjustment for differences between the comparable sales	(68.0	)%	183.9	%	3.7	%
			Income Approach	Capitalization rate	9.2%		10.8	%	9.8	%
Impaired Loans - Commercial	436		Sales comparison approach	Adjustment for differences between the comparable sales	(32.0	)%	30.0	%	(0.1	)%
OREO-Residential	1,555		Sales comparison approach	Adjustment for differences between the comparable sales	(80.0	)%	31.3	%	(1.0	)%
OREO-Commercial	2,519		Sales comparison approach	Adjustment for differences between the comparable sales	(75.8	)%	100.0	%	(1.2	)%
			Income Approach	Capitalization rate	8.9	%	10.5	%	9.5	%
OREO-Construction	3,860		Sales comparison approach	Adjustment for differences between the comparable sales	(63.4	)%	90.0	%	2.4	%
OREO- Commercial and industrial	347		Sales comparison approach	Adjustment for differences between the comparable sales	(63.9	)%	102.9	%	(2.6	)%
			Income Approach	Capitalization rate	9.5	%	11.0	%	10.5	%

For impaired loans and OREO properties at December 31, 2012, the Company utilized independent, third-party appraisals to determine fair value. Independent appraisals are ordered at least annually. As part of the normal appraisal process, the appraisers generally provide the appraised value using one of following techniques: the sales comparison approach, the income approach or a combination thereof. Under the sales comparison approach, the appraiser may make certain adjustments from the sold property to the appraised property, including, but not limited to, differences in square footage, lot size, absorption rates or location. The adjustments between the appraised property and the comparison property ranged from (85.0)% to 131.8% with a weighted average adjustment of 6.00%. Under the income approach, the appraiser may make certain adjustments including, but not limited to, capitalization rates and differences in operating income expectations. The Company's third-party appraisals provided a range of capitalization rates between 8.5% to 22.0% with a weighted average of 7.77%. The Company's third-party appraisals provided a range of adjustments to net operating income expectations of (60.0)% to 100.0% with a weighted average of 26.92%. Due to these adjustments, the appraisals are considered Level 3 measurements. Additionally, the Company monitors the realization rate between proceeds received and appraised value for all sold OREO properties. This discount, defined as the weighted average percentage difference between appraised values and proceeds, is then applied to all remaining appraisals associated with impaired loans and OREO properties. The Company monitors and applies this adjustment to the Company's Level 3 properties. The weighted average discount was approximately 7.82% as of December 31, 2012.

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The following table presents quantitative information about Level 3 fair value measurements for significant items measured at fair value on a non-recurring basis at December 31, 2012.



	Fair value (in thousands)		Valuation technique(s)	Unobservable input(s)	Range				Weighted average
Impaired Loans - CRE	$	727	Sales comparison approach	Adjustment for differences between the comparable sales	(47.5	)%	60.0	%	4.8	%
			Income Approach	Adjustment for differences in net operating income expectations	(10.0	)%	15.0	%	1.3	%
				Capitalization rate	8.0	%	14.8	%	8.0	%
Impaired Loans - Residential	457		Sales Approach	Adjustment for differences between the comparable sales	(51.9	)%	74.0	%	1.1	%
			Income Approach	Adjustment for differences in net operating income expectations	6.0	%	6.0	%	6.0	%
				Capitalization rate	8.8	%	10.0	%	9.7	%
Impaired Loans - Construction	1,783		Sales comparison approach	Adjustment for differences between the comparable sales	(35.0	)%	40.0	%	3.9	%
			Income Approach	Adjustment for differences in net operating income expectations	(44.0	)%	22.0	%	(9.0	)%
			Development Loans	Absorption Rate	3.0	%	33.3	%	20.8	%
			Development Loans	Discount Rate	18.0	%	24.0	%	22.5	%
				Capitalization rate	10.0	%	12.0	%	11.8	%

Impaired Loans - Commercial and Industrial	436		Sales comparison approach	Adjustment for differences between the comparable sales	(74.5	)%	43.5	%	17.0	%
			Income Approach	Adjustment for differences in net operating income expectations	N/A		29.2	%	15.3	%
				Capitalization rate	N/A		22.0	%	10.3	%

OREO-Residential	1,489		Sales comparison approach	Adjustment for differences between the comparable sales	(41.6	)%	58.4	%	8.8	%
OREO-Commercial	2,901		Sales comparison approach	Adjustment for differences between the comparable sales	(85.0	)%	129.1	%	(5.6	)%
			Income Approach	Adjustment for differences in net operating income expectations	(60.0	)%	100.0	%	31.3	%
				Capitalization rate	8.5	%	18.0	%	7.2	%
OREO-Construction	5,279		Sales comparison approach	Adjustment for differences between the comparable sales	(79.0	)%	131.8	%	10.1	%
			Income Approach	Adjustment for differences in net operating income expectations	5.0	%	10.0	%	5.7	%
				Capitalization rate	12.0	%	12.0	%	12.0	%
OREO- Multifamily and Farmland	873		Sales comparison approach	Adjustment for differences between the comparable sales	(10.8	)%	20.8	%	1.0	%
			Income Approach	Adjustment for differences in net operating income expectations	8.0	%	11.6	%	8.5	%
				Capitalization rate	10.0	%	11.0	%	10.8	%

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For impaired loans and OREO properties at September 30, 2012, the Company utilized independent, third-party appraisals to determine fair value. Independent appraisals are ordered at least annually. As part of the normal appraisal process, the appraisers generally provide the appraised value using one of following techniques: the sales comparison approach, the income approach or a combination thereof. Under the sales comparison approach, the appraiser may make certain adjustments from the sold property to the appraised property, including, but not limited to, differences in square footage, lot size, absorption rates or location. The adjustments between the appraised property and the comparison property ranged from (85.0)% to 131.8% with a weighted average adjustment of 4.6%. Under the income approach, the appraiser may make certain adjustments including, but not limited to, capitalization rates and differences in operating income expectations. The Company's third-party appraisals provided a range of capitalization rates between 8.5% to 18.0% with a weighted average of 10.6%. The Company's third-party appraisals provided a range of adjustments to net operating income expectations of (60.0)% to 100.0% with a weighted average of 18.8%. Due to these adjustments, the appraisals are considered Level 3 measurements. Additionally, the Company monitors the realization rate between proceeds received and appraised value for all sold OREO properties. This discount, defined as the weighted average percentage difference between appraised values and proceeds, is then applied to all remaining appraisals associated with impaired loans and OREO properties. The Company monitors and applies this adjustment to the Company's Level 3 properties. The weighted average discount was approximately 17% as of September 30, 2012.

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	Fair value (in thousands)		Valuation technique(s)	Unobservable input(s)	Range				Weighted average
Impaired Loans - CRE	$	8,109	Sales comparison approach	Adjustment for differences between the comparable sales	(34.4	)%	60.0	%	2.8	%
			Income Approach	Adjustment for differences in net operating income expectations	(10.0	)%	100.0	%	24.0	%
				Capitalization rate	9.0	%	14.8	%	10.3	%
Impaired Loans - Residential	3,496		Sales Approach	Adjustment for differences between the comparable sales	(27.5	)%	42.4	%	2.9	%
			Income Approach	Adjustment for differences in net operating income expectations	6.0	%	6.0	%	6.0	%
				Capitalization rate	10.0	%	10.0	%	10.0	%
Impaired Loans - Construction	2,774		Sales comparison approach	Adjustment for differences between the comparable sales	(33.1	)%	36.6	%	4.6	%
			Income Approach	Adjustment for differences in net operating income expectations	(44.0	)%	22.0	%	(9.0	)%
			Development Loans	Absorption Rate	3.0	%	33.3	%	20.8	%
			Development Loans	Discount Rate	18.0	%	24.0	%	22.3	%
				Capitalization rate	12.0	%	12.0	%	12.0	%
OREO-Residential	2,104		Sales comparison approach	Adjustment for differences between the comparable sales	(41.6	)%	58.4	%	9.0	%
OREO-Commercial	4,539		Sales comparison approach	Adjustment for differences between the comparable sales	(85.0	)%	129.1	%	(5.5	)%
			Income Approach	Adjustment for differences in net operating income expectations	(60.0	)%	100.0	%	30.2	%
				Capitalization rate	8.5	%	18.0	%	7.4	%
OREO-Construction	5,644		Sales comparison approach	Adjustment for differences between the comparable sales	(79.0	)%	131.8	%	16.3	%
			Income Approach	Adjustment for differences in net operating income expectations	5.0	%	10.0	%	5.7	%
				Capitalization rate	12.0	%	12.0	%	12.0	%
OREO- Multifamily and Farmland	972		Sales comparison approach	Adjustment for differences between the comparable sales	(10.8	)%	20.8	%	1.0	%
			Income Approach	Adjustment for differences in net operating income expectations	8.0	%	11.6	%	8.5	%
				Capitalization rate	10.0	%	10.7	%	10.1	%

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The following table presents the estimated fair values of the Company’s financial instruments at September 30, 2013, December 31, 2012 and September 30, 2012.



			Fair Value Measurements at
			September 30, 2013 Using:
	Carrying Value		Level 1		Level 2		Level 3		Total
	(in thousands)
Financial assets
Cash and due from banks	$	10,357	$	10,357	$	—	$	—	$	10,357
Interest bearing deposits in banks	59,943		59,943		—		—		59,943
Securities available-for-sale	207,009		—		206,954		55		207,009
Securities held-to-maturity	129,164		—		130,170		—		130,170
Federal Home Loan Bank stock	2,276		N/A		N/A		N/A		N/A
Federal Reserve Bank stock	2,336		N/A		N/A		N/A		N/A
Loans held for sale	1,661		—		1,661		—		1,661
Loans, net	523,927		—		—		533,404		533,404
Accrued interest receivable	3,165		—		1,381		1,784		3,165
Financial liabilities
Deposits	909,848		455,266		458,257		—		913,523
Federal funds purchased and securities sold under agreements to repurchase	12,657		12,657		—		—		12,657
Accrued interest payable	1,039		9		1,030		—		1,039



			Fair Value Measurements at
			December 31, 2012 Using:
	Carrying Value		Level 1		Level 2		Level 3		Total
	(in thousands)
Financial assets
Cash and due from banks	$	12,806	$	12,806	$	—	$	—	$	12,806
Interest bearing deposits in banks	159,665		159,665		—		—		159,665
Securities available-for-sale	254,057		—		254,016		41		254,057
Federal Home Loan Bank stock	2,276		N/A		N/A		N/A		N/A
Federal Reserve Bank stock	1,382		N/A		N/A		N/A		N/A
Loans held for sale	25,920		—		3,624		22,296		25,920
Loans, net	527,330		—		—		545,076		545,076
Accrued interest receivable	2,973		—		947		2,026		2,973
Financial liabilities
Deposits	1,008,066		412,572		600,226		—		1,012,798
Federal funds purchased and securities sold under agreements to repurchase	12,481		12,481		—		—		12,481
Accrued interest payable	1,565		12		1,553		—		1,565

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			Fair Value Measurements at
			September 30, 2012 Using:
	Carrying Value		Level 1		Level 2		Level 3		Total
	(in thousands)
Financial assets
Cash and due from banks	$	10,204	$	10,204	$	—	$	—	$	10,204
Interest bearing deposits in banks	201,631		201,631		—		—		201,631
Securities available-for-sale	257,263		—		256,635		628		257,263
Federal Home Loan Bank stock	2,276		N/A		N/A		N/A		N/A
Federal Reserve Bank stock	1,856		N/A		N/A		N/A		N/A
Loans held for sale	3,857		—		3,857		—		3,857
Loans, net	555,875		—		—		564,930		564,930
Accrued interest receivable	3,202		—		1,014		2,188		3,202
Financial liabilities
Deposits	1,044,131		413,536		636,160		—		1,049,696
Federal funds purchased and securities sold under agreements to repurchase	14,691		14,691		—		—		14,691
Accrued interest payable	1,758		84		1,674		—		1,758

NOTE 14 – FAIR VALUE OPTION

Authoritative accounting guidance provides a fair value option election (FVO) that allows companies to irrevocably elect fair value as the initial and subsequent measurement attribute for certain financial assets and liabilities, with changes in fair value recognized in earnings as they occur. The guidance permits the fair value option election on an instrument by instrument basis at initial recognition of an asset or liability or upon an event that gives rise to a new basis of accounting for that instrument.

The Company records all newly-originated loans held for sale under the fair value option. Origination fees and costs are recognized in earnings at the time of origination. The servicing value is included in the fair value of the loan and recognized at origination of the loan. The Company uses derivatives to hedge changes in servicing value as a result of including the servicing value in the fair value of the loan. The estimated impact from recognizing servicing value, net of related hedging costs, as part of the fair value of the loan is captured in mortgage banking income.

As of September 30, 2013, December 31, 2012 and September 30, 2012, there were $1.7 million, $3.6 million and $3.9 million in loans originated to be held for sale recorded at fair value, respectively. For the three and nine months ended September 30, 2013, approximately $420 thousand and $927 thousand, respectively, in mortgage banking income was recognized. For the three and nine months ended September 30, 2012, approximately $249 thousand and $718 thousand, respectively, in mortgage banking income was recognized.

For the nine months ended September 30, 2013, the Company recognized a loss of $361 thousand due to changes in fair value for loans held for sale in which the fair value option was elected. For the nine months ended September 30, 2012, the Company recognized a gain of $219 thousand due to changes in fair value for loans held for sale in which the fair value option was elected. This amount does not reflect the change in fair value attributable to the related hedges the Company used to mitigate the interest rate risk associated with loans held for sale. The changes in the fair value of the hedges were also recorded in mortgage banking income, and provided income of $320 thousand and $385 thousand for the three and nine months ended September 30, 2013, respectively. The changes in the fair value of the hedges reduced income by $60 thousand and $181 thousand for the three and nine months ended September 30, 2012, respectively.

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The following table provides the difference between the aggregate fair value and the aggregate unpaid principal balance of loans held for sale for which the fair value option has been elected as of September 30, 2013.



	Aggregate fair value		Aggregate unpaid principal balance under FVO		Fair value carrying amount over (under) unpaid principal
	(in thousands)
Loans held for sale	$	1,661	$	1,612	$	49

NOTE 15 – DERIVATIVE FINANCIAL INSTRUMENTS

The Company records all derivative financial instruments at fair value in the financial statements. It is the policy of the Company to enter into various derivatives both as a risk management tool and in a dealer capacity, as necessary, to facilitate client transactions. Derivatives are used as a risk management tool to hedge the exposure to changes in interest rates or other identified market risks. As of September 30, 2013, the Company has not entered into a transaction in a dealer capacity.

When a derivative is intended to be a qualifying hedged instrument, the Company prepares written hedge documentation that designates the derivative as (1) a hedge of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or (2) a hedge of a forecasted transaction, such as the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).

The written documentation includes identification of, among other items, the risk management objective, hedging instrument, hedged item, and methodologies for assessing and measuring hedge effectiveness and ineffectiveness, along with support for management’s assertion that the hedge will be highly effective. Methodologies related to hedge effectiveness and ineffectiveness include (1) statistical regression analysis of changes in the cash flows of the actual derivative and a perfectly effective hypothetical derivative, (2) statistical regression analysis of changes in fair values of the actual derivative and the hedged item and (3) comparison of the critical terms of the hedged item and the hedging derivative. Changes in fair value of a derivative that is highly effective and that has been designated and qualifies as a fair value hedge are recorded in current period earnings, along with the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. Changes in the fair value of a derivative that is highly effective and that has been designed and qualifies as a cash flow hedge are initially recorded in other comprehensive income and reclassified to earnings in conjunction with the recognition of the earnings impacts of the hedged item; any ineffective portion is recorded in current period earnings. Designated hedge transactions are reviewed at least quarterly for ongoing effectiveness. Transactions that are no longer deemed to be effective are removed from hedge accounting classification and the recorded impacts of the hedge are recognized in current period income or expense in conjunction with the recognition of the income or expense on the originally hedged item.

The Company’s derivatives are based on underlying risks, primarily interest rates. The Company utilizes zero premium collars and interest rate swaps to reduce the risks associated with interest rates. Swaps are contracts in which a series of net cash flows, based on a specific notional amount that is related to an underlying risk, are exchanged over a prescribed period. The Company also utilizes forward contracts on the held-for-sale loan portfolio. The forward contracts hedge against changes in fair value of the held-for-sale loans.

Derivatives expose the Company to credit risk. If the counterparty fails to perform, the credit risk is equal to the fair value gain of the derivative. The credit exposure for swaps is the replacement cost of contracts that have become favorable. Credit risk is minimized by entering into transactions with high quality counterparties that are initially approved by the Board of Directors and reviewed periodically by the Asset/Liability Committee. It is the Company’s policy of requiring that all derivatives be governed by an International Swap and Derivatives Associations Master Agreement (ISDA). Bilateral collateral agreements may also be required.

During the nine months ended September 30, 2013, the Company entered into into various derivative contracts with a gross notional value of $3.1 million. The derivatives were utilized in lending transactions to minimize interest rate risks by converting fixed rate cash flows into variable rate cash flows.

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On August 28, 2007 and March 26, 2009, the Company elected to terminate a series of interest rate swaps with a total notional value of $150 million and $50 million, respectively. At termination, the swaps had market values of $2.0 million and $5.8 million, respectively. These gains are being accreted into interest income over the remaining lives of the originally hedged items. The Company did not recognized any income during the three and nine months ended September 30, 2013, and $410 thousand and $1.3 million, respectively, for the three and nine months ended September 30, 2012. As of December 31, 2012 the swaps were fully accreted into interest income.

The following table presents the cash flow and fair value hedges as of September 30, 2013.



	Notional Amount		Gross Unrealized Gains		Gross Unrealized Losses			Accumulated Other Comprehensive Income			Maturity Date
	(in thousands)
Asset hedges
Cash flow hedges:
Forward loan sales contracts	$	1,661	$	—	$	49		$	(77	)	Various
Fair Value hedges:
Zero premium collar	1,542		33		—			—			June 10, 2023
Cash flow swap	1,542		—		(33		)	—			June 10, 2023
	$	4,745	$	33	$	16		$	(77	)

The following table presents additional information on the active derivative positions as of September 30, 2013.

Consolidated Balance

Sheet Presentation

Consolidated Income

Statement Presentation

Assets

Liabilities

Gains

Notional

Classification

Amount

Classification

Amount

Classification

Amount

Recognized

(in thousands)

Hedging Instrument:

Forward contracts

1,661

Other assets

—

Other liabilities

Noninterest

income – other

Zero premium collar

1,542

Other assets

Other liabilities

N/A

Noninterest income – other

Cash flow swap

1,542

Other assets

N/A

Other liabilities

Noninterest expense – other

Hedged Items:

Loans held for sale

N/A

Loans held for

sale

1,661

N/A

Noninterest

income – other

N/A

Loans

N/A

Loans

1,542

N/A

Noninterest

income – other

N/A

For the three and nine months ended September 30, 2013, no significant amounts were recognized for hedge ineffectiveness.

NOTE 16 – RECENT ACCOUNTING PRONOUNCEMENTS

No significant new accounting guidance became effective for the Company for the nine months ended September 30, 2013. As of September 30, 2013 there was no issued guidance that is expected to have a significant impact on the Company's consolidated financial statements when adopted.

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

In this Form 10-Q, “First Security,” “we,” “us,” “the Company” and “our” refer to First Security Group, Inc.

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” ("MD&A") and elsewhere throughout this Form 10-Q are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements relate to future events or our future financial performance and include statements about the Company's plans for raising capital, the Company's future growth and market position, and the execution of its business plans. When we use words like “may,” “plan,” “contemplate,” “anticipate,” “believe,” “intend,” “continue,” “expect,” “project,” “predict,” “estimate,” “could,” “should,” “would,” “will,” and similar expressions, you should consider them as identifying forward-looking statements, although we may use other phrasing. These forward-looking statements involve risks and uncertainties and are based on our beliefs and assumptions, and on the information available to us at the time that these disclosures were prepared.

These forward-looking statements involve risks and uncertainties and may not be realized due to a variety of factors. There can be no assurance that the results, performance or achievements of the Company will not differ materially from those expressed or implied by forward-looking statements. Factors that could cause actual events or results to differ significantly from those described in the forward-looking statements include, but are not limited to, 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. For details on these and other factors that could affect expectations, see the cautionary language included under the headings “Risk Factors” and “Management's Discussion and Analysis of Financial Condition and Results of Operations” in the Company's Annual Report on Form 10-K for the year ended December 31, 2012, subsequent Quarterly Reports on Form 10-Q and other filings with the SEC.

Many of these risks are beyond our ability to control or predict, and you are cautioned not to put undue reliance on such forward-looking statements. First Security does not intend to update or reissue any forward-looking statements contained in this release as a result of new information or other circumstances that may become known to First Security, and undertakes no obligation to provide any such updates.

All written or oral forward-looking statements attributable to us are expressly qualified in their entirety by this Note. Our actual results and condition may differ significantly from those we discuss in these forward-looking statements.

THIRD QUARTER 2013 AND RECENT EVENTS

The following discussion and analysis sets forth the major factors that affected the results of operations and financial condition reflected in the unaudited financial statements for the three and nine months ended September 30, 2013 and 2012. Such discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and the notes attached thereto, which are included in this Form 10-Q.

Company Overview

First Security Group, Inc. is a bank holding company headquartered in Chattanooga, Tennessee, with $1.0 billion in assets as of September 30, 2013. Founded in 1999, First Security’s community bank subsidiary, FSGBank, N.A. ("FSGBank"), currently has 30 full-service banking offices, including the headquarters, along the interstate corridors of eastern and middle Tennessee and northern Georgia and 313 full-time equivalent employees. In Dalton, Georgia, FSGBank operates under the name of Dalton Whitfield Bank; along the Interstate 40 corridor in Tennessee, FSGBank operates under the name of Jackson Bank & Trust. FSGBank provides retail and commercial banking services, trust and investment management, mortgage banking, financial planning and Internet banking (www.FSGBank.com) services.

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Strategic Initiatives for 2013

Over the last two years, our focus has largely been two-fold: addressing the capital needs of the Bank and implementing our business strategy. During the second quarter of 2013, we completed the Recapitalization (defined below) that we believe helped to satisfy our near and longer-term capital needs. In connection with the Recapitalization, we further enhanced our board of directors with the addition of two additional directors. Immediately following the capital infusion, we accelerated our balance sheet restructuring strategy within our business plan. Additionally, we began a process to identify and reduce certain aspects of non-interest expense. We believe that the full implementation of our business plan will position us appropriately for both short-term and long-term success.

Strategic Initiative—Strengthening Capital—On April 12, 2013, we announced the completion of our Recapitalization. The Recapitalization included a conversion of the TARP CPP Preferred Stock to common stock as well as an additional issuance of common stock to institutional and other accredited investors. On April 11, 2013, we issued approximately 9.9 million shares of our common stock to the U.S. Treasury ("Treasury") for full satisfaction of the Treasury TARP CPP investment, including all associated dividends and warrants. The Treasury immediately sold the common stock to institutional and other accredited investors previously identified by First Security for $1.50 per share. On April 12, 2013, we issued an additional approximately 50.8 million shares of common stock at $1.50 per share to institutional and other accredited investors. In aggregate, investors purchased 60,735,000 shares for $91.1 million, or $1.50 per share. On April 12, 2013, we downstreamed $65.0 million to FSGBank to improve FSGBank's regulatory capital ratios and to support future balance sheet growth (collectively, the "Recapitalization"). See Note 2 to our Consolidated Financial Statements for additional discussion.

As part of the Recapitalization, we initiated a rights offering (the "Rights Offering") during the third quarter of 2013 for shareholders of record as of April 10, 2013, the business day immediately preceding the Recapitalization (the "Legacy Shareholders"). The Rights Offering was previously announced on a Current Report on Form 8-K filed on February 26, 2013. Under the Rights Offering, each Legacy Shareholder received one non-transferable subscription right to purchase two shares of the Company's common stock at the subscription price of $1.50 per share for every one share of common stock owned by such Legacy Shareholder as of the record date of April 10, 2013. Additionally, each Legacy Shareholder that fully exercised such Legacy Shareholder's subscription rights had the ability to submit an over-subscription request to purchase additional shares of common stock, subject to certain limitations and subject to allotment under the Rights Offering. On September 27, 2013, we completed the fully subscribed Rights Offering by issuing 3,329,234 shares of common stock for $1.50 per share for gross proceeds of approximately $5.0 million. On September 27, 2013, First Security Group downstreamed $6.4 million, which included the net proceeds from the Rights Offering as well as additional available cash, as a cash contribution to FSGBank to further supplement the Bank's regulatory capital.

Strategic Initiative—Strengthening Board of Directors—During the first quarter of 2012, three additional directors were appointed to our board. Mr. William F. Grant, III and Mr. Robert R. Lane were appointed pursuant to the terms of the Series A Preferred Stock, as elected by the Treasury. The third director, Larry D. Mauldin, was appointed as the new independent Chairman of the Board.

As a result of the Recapitalization and pursuant to the TARP CPP regulations, the board seats previously occupied by Mr. Grant and Mr. Lane were eliminated. Both Mr. Grant and Mr. Lane were simultaneously re-appointed to the board as common stock directors. The Recapitalization also provided MFP Partners, L.P. ("MFP") and Ulysses Partners, L.P. ("Ulysses") the right to each designate an individual to serve as a director, subject to regulatory non-objection. On May 15, 2013, we elected Mr. Adam Hurwich to the boards of First Security Group and FSGBank as Ulysses' representative. Mr. Hurwich has served as portfolio manager for Ulysses since 2009. In addition to his investment management background, Mr. Hurwich also serves as a member of the Financial Accounting Standards Advisory Council, an advisory committee for the Financial Accounting Standards Board. On June 19, 2013, we elected Ms. Henchy Enden to the boards of the First Security Group and FSGBank as MFP's representative. Ms. Enden currently serves as Equity Analyst for MFP Investors LLC. Ms. Enden also served as director on West Coast Bancorp and West Coast Bank.

On March 19, 2013, Mr. Ralph Kendall, a founding director, resigned from the boards. Mr. Kendall recently moved to Texas to be closer to his family. On May 13, 2013, Mr. Robert P. Keller resigned from the boards. Mr. Keller's resignation letter does not indicate any disagreements with First Security's operations, policies or practices.

We believe our current Board members possess the level of banking, small business and leadership backgrounds which will allow it to provide a strong level of oversight to our management team. The Board is focused on establishing an overall business strategy that supports out fundamental objectives of creating long-term stockholder value.

Strategic Initiative—Improving Asset Quality— On December 10, 2012, we entered into an asset purchase agreement with a third party to sell certain loans. During the fourth quarter of 2012, we identified $36.2 million of under- and non-performing loans to sell and recorded a $13.9 million loss to reduce the loan balance to the expected net proceeds. During the first quarter of 2013, we recorded $1.4 million in transaction expenses and another $671.1 thousand in the third quarter of 2013. The aggregate expense associated with the loan sale was $16.0 million.

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During 2013, we have continued to improve our asset quality. As of September 30, 2013, our asset quality ratios are better than or comparable to those of our peer group. Our peer group, as defined by the Uniform Bank Performance Report (UBPR), is all commercial banks between $1 billion and $3 billion in total assets. For the remainder of 2013, we expect continued improvement in asset quality, with emphasis on reductions in our OREO balance.

Strategic Initiative—Balance Sheet Restructuring

Deposits—A cornerstone of our business plan is to advance our deposit market share within our footprint through a focus on growth in pure deposits, defined as transaction accounts. In the preceding twelve months and over the next twelve months, we have and will experience significant maturities of brokered deposits. These maturities provide an opportunity to restructure the deposit mix with a shift towards lower cost funding. To support this initiative, we established clearly defined pure deposit growth objectives for each of our 30 branch locations and aligned our retail incentive plans accordingly. Leveraging our branches to grow market share with pure deposits will reduce our cost of funds, increase our margin and assisting us in achieving overall profitability.

During 2013, we are generating positive results in implementing our retail deposit strategy. From December 31, 2012 to September 30, 2013, $76.5 million of brokered deposits matured while pure deposits increased $42.7 million, or 10.3%, during the same time-frame. Pure deposits increased $41.7 million, or 10.1%, from September 30, 2012 to September 30, 2013.

For the remainder of 2013, we expect to continue to grow pure deposits through increases in products per household and by acquiring new customer relationships. As discussed below, we also anticipate using a portion of our excess liquidity to fund maturing higher cost certificates of deposits as well as brokered deposits.

Investment Securities and Liquidity—We have maintained excess liquidity since 2009, as described below, to reduce our liquidity risk given our credit and financial condition prior to the Recapitalization. During the second quarter of 2013, we began deploying the excess liquidity into investment securities by purchasing approximately $83.6 million since March 31, 2013. During the third quarter of 2013, we transfered certain federal agency, mortgage-based and municipal securities with a fair value of approximately $129.1 million from the available-for-sale portfolio to the held-to-maturity portfolio. As of the transfer date, the unrealized holding loss was approximately $8.7 million. This unrealized loss will continue to be reported as a separate component of shareholders' equity and will be amortized over the remaining life of the securities as an adjustment to the yield. The corresponding discount on these securities will offset this adjustment to yield for no income statement impact. The securities identified primarily consisted of securities with excessive price risk in higher interest rate environments. Additional deployments of cash will be considered based on our liquidity position and investment opportunities, which may also include utilizing the excess liquidity to fund maturing deposits.

Between December of 2009 and the first quarter of 2010, we issued over $180.0 million in brokered deposits to improve our contingent funding capacity. A majority of these funds were placed in our interest bearing account at the Federal Reserve Bank of Atlanta. We executed this liquidity strategy to provide stability and the ability to fund multiple years of obligations without relying on deposit growth or additional borrowings.

As of September 30, 2013, our total interest-bearing cash was $59.9 million compared to $201.6 million at September 30, 2012.

Loans— As of September 30, 2013, our loan to deposit ratio was 58.8% and average loans for the third quarter accounted for 57.1% of total average earning assets. While cost reductions and revenue enhancements are being implemented, the return to profitability is largely associated with increasing loans and shifting the mix of earning assets from investment securities into loans. Subsequent to the completion of the Recapitalization, various lending opportunities were evaluated to enhance and expedite loan growth while maintaining our commitment to asset quality in value-added niches. At this time, four niche lending initiatives are being implemented. First, TriNet Direct is a new division focused on national net lease lending and includes three full-time equivalent employees. This unit will originate construction of pre-leased "build to suit" projects and provide interim and long-term financing to professional developers and private investors of commercial real estate on long-term leases to tenants that are investment grade or have investment grade attributes. Second, we have also entered into a partnership with an unaffiliated third-party that originates small balance, unsecured consumer loans, primarily associated with home improvement additions, including financing new or replacement HVAC units, roofs, windows and other improvements. We are purchasing these consumer loans at a discount from the originator. Third, we are currently building the sales and support team necessary to originate structured loans secured by accounts receivables and inventory within our markets. We believe properly structured and monitored asset-based lending at the community bank level is an under-served market that will generate above-average return on a risk-adjusted basis. The fourth lending initiative is a lending unit focused on government lending, primarily originating and selling the guaranteed portion of SBA and USDA loans. This fourth initiative will provide a greater impact on non-interest income through the premium and servicing of sold loans. Collectively, we believe that our traditional banking officers, supplemented by these lending initiatives, will significantly impact our loans balances within the next twelve months and be the primary contributor to our return to core profitability.

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Overall, we believe a disciplined approach to managing our earning asset mix will improve our yield on earning assets, increase our margin and assist us in achieving overall profitability.

Strategic Initiative—Non-Interest Expense Management

During the second quarter of 2013, we engaged a consultant to review and analyze all aspects of non-interest expense. The consultant facilitated a process that involved multiple employee teams. Each team reviewed a department or line of business and provided recommendations where appropriate. The process included the evaluation of the effectiveness and profit contribution of each branch, staffing levels throughout each department or line of business and various process improvements.

During the third quarter of 2013, we began the process of implementing the recommendations. In reviewing the retail branches, various efficiencies were identified that supported a reduction in staffing as well as a shift towards better utilizing part-time employees during peak transaction times. Reductions in the special assets and certain administrative functions were also identified. Collectively, we reduced our employee base by approximately 30 full-time equivalent employees, or 10% of our workforce. In addition, two branches will close by December 31, 2013. Various other cost savings were identified and are being implemented as appropriate.

Regulatory Relations

Effective September 7, 2010, First Security entered into the Agreement with the Federal Reserve Bank. The Agreement is designed to ensure that First Security is a source of strength to FSGBank. Substantially all of the requirements of the Agreement are similar to those already in effect for FSGBank pursuant to the Consent Order that is described below. On September 14, 2010, we filed a Current Report on Form 8-K describing the Agreement. The Form 8-K also provides a copy of the fully executed Agreement.

We are currently deemed not in compliance with some provisions of the Agreement. Any material noncompliance may result in further enforcement actions by the Federal Reserve Bank. We can provide no assurances that we will be able to comply fully with the Agreement, that efforts to comply with the Agreement will not have a material adverse effect on the operations and financial condition of First Security, or that further enforcement actions will not be imposed on First Security.

Effective April 28, 2010, FSGBank reached an agreement with its primary regulator, the OCC, regarding the issuance of a Consent Order. The Order is a result of the OCC’s regular examination of FSGBank in the fall of 2009 and directs FSGBank to take actions intended to strengthen its overall condition. All customer deposits remain fully insured by the FDIC to the maximum extent allowed by law; the Order does not impact this coverage in any manner. On April 29, 2010, First Security filed a Current Report on Form 8-K describing the Order. The Form 8-K also provides a copy of the fully executed Order.

Based on the last regulatory examination, the Bank is currently deemed not in compliance with certain provisions of the Order, including the capital requirements. Management believes that the completed Recapitalization and Rights Offering, as well as the full implementation of the business plan, will provide compliance with most requirements of the Order. However, in determining full compliance, multiple factors may be considered, including a certain period of time after implementation. Accordingly, we can provide no assurances as to the timing, if at all, of relief from the Order.

The Order required FSGBank to maintain a total risk-based capital ratio of at least 13.0% and a Tier 1 leverage ratio of at least 9.0%. As of September 30, 2013, the Bank’s total capital to risk-weighted assets was 14.94% and the Tier 1 capital to adjusted total assets was 8.33%. The Bank has notified the OCC of the non-compliance with the Tier 1 leverage ratio requirement of the Order. See Note 2 to our consolidated financial statements for additional information regarding our strategic and capital plans.

As of September 30, 2013, all regulatory capital ratios exceed the percentages of a well capitalized institution as defined under applicable regulatory guidelines. However, FSGBank will continue to be classified as adequately capitalized due to the capital requirements in the Order.

Overview

Market Conditions

Our financial results are impacted by both macro-economic and micro-economic conditions. We monitor key indicators on the national, regional and local levels and incorporate applicable trends into our risk tolerances.

As changes in interest rates have a direct impact on our financial results, we monitor the actions and guidance provided by the Federal Open Market Committee ("FOMC") as well as certain key rates. In December 2012, FOMC provided guidance that linked changes in the federal funds rate to unemployment reaching 6.5% and the outlook for inflation being no higher than 2.5%. Additionally, the FOMC stated that tapering of Quantitative Easing 3 ("QE3") would be in stages with the conclusion of QE3 purchases when unemployment reached 7.0%. Over the last six months, the yield on the 10-year Treasury increased from approximately 1.87% as of March 31, 2013 to approximately 2.64% as of September 30, 2013. Most believe that the increase was a direct result of the comments surrounding the tapering of QE3 as well as continued improvement in economic data. We

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are actively monitoring our interest rate sensitivity and investment duration as it relates to our cash deployment strategy and overall balance sheet.

As of September 2013, the national unemployment rate improved to 7.2% from 7.6% as of June 2013. As of August 2013, the latest available state level data, the unemployment rates in Tennessee and Georgia were 8.3% and 8.3%, respectively. Our primary markets of Chattanooga and Knoxville, Tennessee continue to have better unemployment rates than the state average. As of August 2013, the unemployment rates for Chattanooga and Knoxville, Tennessee are 8.0% and 7.1%, respectively.

In addition to key trends, we also monitor specific economic investments in our market area. The following are recent or significant announcements:


•	Dalton, Georgia - Engineered Floors will invest $450 million to build two manufacturing complexes over the next five years that will create approximately 2,400 jobs. The new manufacturing complexes will be in Murray and Whitfield counties in Georgia.


•	Knoxville, Tennessee - Alcoa Inc. is planning to expand their current Blount County plants with an investment of $275 million. Alcoa expect to add approximately 200 permanent jobs over the next three years. The new plant will support Tennessee's automotive industry by producing aluminum products.


•	Chattanooga, Tennessee - Amazon.com opened two distribution centers in our markets in 2011 and subsequently expanded the center in Hamilton county. The initial $139 million investments created more than 2,000 full-time jobs and an additional 2,000 seasonal jobs in Hamilton and Bradley counties.

•

Chattanooga, Tennessee - The $1 billion Volkswagen automotive production facility has produced more than 100,000 Passats since production began on May 24, 2011. Volkswagen has invested $1 billion in the local economy for the Chattanooga plant and created more than 2,200 direct jobs in the region. According to independent studies, the Volkswagen plant is expected to generate $12 billion in income growth and an additional 9,500 jobs related to the project.


•	Cleveland, Tennessee - Wacker Chemical is building a $1.8 billion polysilicon production plant for the solar power industry near Cleveland, Tennessee. The plant is expected to create an additional 600 direct jobs for our market area, with the current staffing level of approximately 280.

We believe the positive economic impact of the above and other recently announced economic investments will be significant and provide a highly competitive economic growth rate.

Financial Results

As of September 30, 2013, we had total consolidated assets of $1.0 billion, total loans of $534.6 million, total deposits of $909.8 million and shareholders’ equity of $83.4 million. For the three and nine months ended September 30, 2013, our net income available (loss allocated) to common shareholders was ($1.4) million and $12.0 million, respectively, resulting in basic net loss of $0.02 per share and diluted net loss of $0.02 per share for the quarter and basic net income of $0.30 per share and diluted net income of $0.30 per share for the year-to-date period. During the second quarter of 2013, we recognized a credit to retained earnings of $26.2 million on the conversion of our Preferred Stock to common stock in connection with the CPP Restructuring.

As of September 30, 2012, we had total consolidated assets of $1.1 billion, total loans of $573.4 million, total deposits of $1.0 billion and shareholders’ equity of $44.7 million. For the three and nine months ended September 30, 2012, our net loss allocated to common shareholders was $9.4 million and $23.5 million, respectively, resulting in basic net loss of $5.79 per share and diluted net loss of $5.79 per share for the quarter and basic net loss of $14.54 per share and diluted net loss per share of $14.54 for the year-to-date period.

For the three and nine months ended September 30, 2013, net interest income increased by $316 thousand and decreased by $1.5 million, respectively, and noninterest income decreased by $180 thousand and increased by $266 thousand, respectively, compared to the same period in 2012. For the three and nine months ended September 30, 2013, noninterest expense decreased by $1.4 million and increased by $1.1 million, respectively, compared to the same period in 2012. The increase in net interest income for the three months ended September 30, 2013 is primarily due to reduced interest expense from lower interest rates and a reduction in brokered deposits. The decline for the nine months ended September 30, 2013 in net interest income is primarily attributable to a reduction in our average loan portfolio. Noninterest income decreased for the three months ended September 30, 2013, primarily due a decrease in the gain on sales of securities, while noninterest expense decreased for the quarter primarily due to a decrease in our FDIC assessment, partially offset by an increase in salary expense. Noninterest income increased for the nine months ended September 30, 2013, primarily due to gains on sales of securities available for sale and higher fees related to origination of loans held for sale, while noninterest expense increased for the year

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primarily due to higher salary and benefit expenses. Full-time equivalent employees were 313 at September 30, 2013, compared to 328 at September 30, 2012.

The provision for loan and lease losses decreased $6.2 million and $12.3 million for the three and nine month periods ended September 30, 2013 compared to the same periods in 2012. The provision expense is based on the quarterly evaluation of the adequacy of the allowance for loan and lease losses, as described below.

Our efficiency ratio decreased in the third quarter of 2013 to 131.6% compared to 149.6% in the same period of 2012 primarily due to an increase in net interest income combined with a decrease in noninterest expense. We anticipate our efficiency ratio to continue to improve during the fourth quarter of 2013 as we focus on enhancing revenue while continuing to reduce certain overhead expenses. However, improvement of our efficiency ratio over the balance of 2013 is contingent on both macro-economic factors, such as potential changes to the federal funds target rate, and micro-economic factors, such as local unemployment and real estate values.

Net interest margin in the third quarter of 2013 was 2.71%, or 0.41% higher than the prior year period of 2.30%. Net interest margin for the nine months ended September 30, 2013 was 2.38%, or 0.06% lower than the same period in 2012. We anticipate that our margin will improve during the remainder of 2013 as higher cost brokered deposits mature and are replaced with lower cost core deposits as well as anticipated loan growth. The projected improvement of our net interest margin is dependent on multiple factors including our ability to raise core deposits, our growth or contraction in loans, our deposit and loan pricing, maturities of brokered deposits, and any possible action by the Federal Reserve Board to the target federal funds rate.

Pursuant to the Agreement, the Company is prohibited from declaring or paying dividends without the prior written consent of the Federal Reserve. Any future determination relating to dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, regulatory restrictions, and other factors that our Board of Directors may deem relevant. Our ability to distribute cash dividends in the future may be limited by regulatory restrictions and the need to maintain sufficient consolidated capital.

RESULTS OF OPERATIONS

We reported net income available (loss allocated) to common shareholders for the three and nine month periods ended September 30, 2013 of ($1.4) million and $12.0 million, respectively, compared to a net loss allocated to common shareholders for the same periods in 2012 of $9.4 million and $23.5 million, respectively. For the three and nine months ended September 30, 2013, basic earnings (loss) per share was $(0.02) and $0.30, respectively, and diluted earnings per share was $(0.02) and $0.30, respectively, on approximately 62.6 million and 40.0 million, respectively, weighted average shares outstanding for both basic and diluted.

Net loss allocated to common shareholders decreased by $8.0 million for the three months ended September 30, 2013 and net income available to common shareholders for the nine months ended September 30, 2013 increased by $35.5 million, compared to the net losses allocated to common shareholders of $9.4 million and $23.5 million reported in the same periods for 2012. This was primarily a result of the Recapitalization transactions that took place in April 2013. See Note 2 to our consolidated financial statements for additional information. As of September 30, 2013, we had 30 banking offices, including the headquarters, and 313 full-time equivalent employees.

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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, 2013 compared to the same periods in 2012.

CONDENSED CONSOLIDATED INCOME STATEMENT



	For the Three Months Ended			Change from Prior Year					For the Nine Months Ended			Change from Prior Year
	September 30, 2013			Amount			Percentage		September 30, 2013			Amount			Percentage
	(in thousands, except percentages)
Interest income	$	8,171		$	(803	)	(8.9	)%	$	23,767		$	(4,477	)	(15.9	)%
Interest expense	2,006			(1,119		)	(35.8	)%	6,874			(2,981		)	(30.2	)%
Net interest income	6,165			316			5.4	%	16,893			(1,496		)	(8.1	)%
(Credit) Provision for loan and lease losses	(1,632		)	(6,175		)	(135.9	)%	(1,780		)	(12,272		)	(117.0	)%
Net interest income after provision for loan and lease losses	7,797			6,491			497.0	%	18,673			10,776			136.5	%
Noninterest income	2,514			(180		)	(6.7	)%	7,255			266			3.8	%
Noninterest expense	11,419			(1,362		)	(10.7	)%	38,372			1,092			2.9	%
Net loss before income taxes	(1,108		)	7,673			(87.4	)%	(12,444		)	9,950			(44.4	)%
Income tax provision	322			214			198.1	%	358			760			(189.1	)%
Net loss	(1,430		)	7,459			(83.9	)%	(12,802		)	9,190			(41.8	)%
Preferred stock dividends	—			(413		)	(100.0	)%	(929		)	(309		)	(49.8	)%
Accretion on Preferred Stock Discount	—			(108		)	(100.0	)%	(452		)	134			22.9	%
Effect of exchange of Preferred Stock to Common Stock	—			—			—	%	26,179			26,179			100.0	%
Net (loss allocated) income available to common shareholders	$	(1,430	)	$	7,980		(84.8	)%	$	11,996		$	35,544		(150.9	)%

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. For the quarter ended September 30, 2013, net interest income increased by $316 thousand, or 5.4%, to $6.2 million compared to $5.8 million for the same period in 2012. For the nine months ended September 30, 2013, net interest income decreased by $1.5 million, or 8.1%, to $16.9 million compared to $18.4 million for the same period in 2012.

We monitor and evaluate the effects of certain risks on our earnings and seek balance between the risks assumed and returns sought. Some of these risks include interest rate risk, credit risk and liquidity risk.

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.

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The following tables summarize net interest income and average yields and rates paid for the quarters ended September 30, 2013 and 2012.

AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST ANALYSIS

FULLY TAX EQUIVALENT BASIS



	For the Three Months Ended
	September 30,
	2013							2012
	Average Balance			Income/ Expense		Yield/ Rate		Average Balance			Income/ Expense		Yield/ Rate
	(in thousands, except percentages)
ASSETS
Earning assets:
Loans, net of unearned income ⁽¹⁾	$	529,406		$	6,461	4.84	%	$	593,164		$	7,722	5.18	%
Securities – taxable ⁽²⁾	289,226			1,333		1.83	%	230,159			912		1.58	%
Securities – non-taxable ⁽²⁾	40,159			475		4.69	%	24,203			346		5.69	%
Other earning assets	68,964			77		0.44	%	187,248			121		0.26	%
Total earning assets	927,755			8,346		3.57	%	1,034,774			9,101		3.50	%
Allowance for loan and lease losses	(12,599		)					(21,421		)
Intangible assets	405							726
Cash & due from banks	13,785							13,162
Premises & equipment	28,957							29,525
Other assets	58,616							60,728
TOTAL ASSETS	$	1,016,919						$	1,117,494
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest bearing liabilities:
Interest bearing demand deposits	$	93,095		62		0.26	%	$	63,611		52		0.33	%
Money market accounts	175,276			179		0.41	%	143,478			228		0.63	%
Savings deposits	40,329			9		0.09	%	40,383			19		0.19	%
Time deposits of less than $100 thousand	198,665			466		0.93	%	232,616			657		1.12	%
Time deposits of $100 thousand or more	176,882			475		1.07	%	200,891			631		1.25	%
Brokered CDs and CDARS®	90,323			795		3.49	%	193,245			1,420		2.92	%
Repurchase agreements	14,206			20		0.56	%	15,089			118		3.11	%
Total interest bearing liabilities	788,776			2,006		1.01	%	889,313			3,125		1.40	%
Net interest spread				$	6,340	2.56	%				$	5,976	2.10	%
Noninterest bearing demand deposits	145,679							162,338
Accrued expenses and other liabilities	3,082							13,662
Shareholders’ equity	88,285							49,014
Accumulated other comprehensive income	(8,903		)					3,167
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	1,016,919						$	1,117,494
Impact of noninterest bearing sources and other changes in balance sheet composition						0.15	%						0.20	%
Net interest margin						2.71	%						2.30	%

__________________


(1)	Nonaccrual loans have been included in the average balance. Only the interest collected on such loans has been included as income.

(2)

Interest income from securities includes the effects of taxable-equivalent adjustments using a federal income tax rate of approximately 34% for both years reported and where applicable, state income taxes, to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable equivalent adjustment amounts included in the above table were $175 thousand and $227 thousand for the quarters ended September 30, 2013 and 2012, respectively.

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The following table presents the relative impact on net interest income to changes in the average outstanding balances (volume) of earning assets and interest bearing liabilities and the rates earned and paid by us on such assets and liabilities. Variances resulting from a combination of changes in rate and volume are allocated in proportion to the absolute dollar amount of the change in each category.

CHANGE IN INTEREST INCOME AND EXPENSE ON A TAX EQUIVALENT BASIS

FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2013 COMPARED TO 2012



	Increase (Decrease) in Interest Income and Expense Due to Changes in:
	Volume			Rate			Total
	(in thousands)
Interest earning assets:
Loans, net of unearned income	$	(797	)	$	(464	)	$	(1,261	)
Securities – taxable	257			164			421
Securities – non-taxable	197			(68		)	129
Other earning assets	(102		)	58			(44		)
Total earning assets	(445		)	(310		)	(755		)
Interest bearing liabilities:
Interest bearing demand deposits	21			(11		)	10
Money market accounts	44			(93		)	(49		)
Savings deposits	—			(10		)	(10		)
Time deposits of less than $100 thousand	(89		)	(102		)	(191		)
Time deposits of $100 thousand or more	(70		)	(86		)	(156		)
Brokered CDs and CDARS^®	(865		)	240			(625		)
Repurchase agreements	(7		)	(91		)	(98		)
Total interest bearing liabilities	(966		)	(153		)	(1,119		)
Increase (decrease) in net interest income	$	521		$	(157	)	$	364

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The following tables summarize net interest income and average yields and rates paid for the year-to-date periods ended September 30, 2013 and 2012.

AVERAGE CONSOLIDATED BALANCE SHEETS AND NET INTEREST ANALYSIS

FULLY TAX EQUIVALENT BASIS



	For the Nine Months Ended
	September 30,
	2013							2012
	Average Balance			Income/ Expense		Yield/ Rate		Average Balance			Income/ Expense		Yield/ Rate
	(in thousands, except percentages)
ASSETS
Earning assets:
Loans, net of unearned income ⁽¹⁾	544,136			19,537		4.80	%	595,278			24,289		5.45	%
Securities – taxable ⁽²⁾	262,184			3,169		1.62	%	205,651			2,813		1.83	%
Securities – non-taxable ⁽²⁾	29,514			1,141		5.17	%	28,019			1,189		5.67	%
Other earning assets	137,291			338		0.33	%	201,663			387		0.26	%
Total earning assets	973,125			24,185		3.32	%	1,030,611			28,678		3.72	%
Allowance for loan and lease losses	(13,581		)					(20,440		)
Intangible assets	501							825
Cash & due from banks	12,271							12,701
Premises & equipment	29,151							29,158
Other assets	54,144							64,976
TOTAL ASSETS	1,055,611							1,117,831
LIABILITIES AND SHAREHOLDERS’ EQUITY
Interest bearing liabilities:
Interest bearing demand deposits	89,465			213		0.32	%	60,322			128		0.28	%
Money market accounts	159,479			594		0.50	%	132,578			767		0.77	%
Savings deposits	40,066			34		0.11	%	40,122			64		0.21	%
Time deposits of less than $100 thousand	217,236			1,551		0.95	%	231,690			2,063		1.19	%
Time deposits of $100 thousand or more	196,004			1,558		1.06	%	197,804			1,948		1.32	%
Brokered CDs and CDARS®	125,299			2,873		3.07	%	205,028			4,538		2.96	%
Repurchase agreements	13,549			51		0.50	%	15,509			346		2.98	%
Other borrowings	—			—		—	%	17			1		7.86	%
Total interest bearing liabilities	841,098			6,874		1.09	%	883,070			9,855		1.49	%
Net interest spread				$	17,311	2.23	%				$	18,823	2.23	%
Noninterest bearing demand deposits	139,816							161,079
Accrued expenses and other liabilities	9,038							13,772
Shareholders’ equity	65,863							56,355
Accumulated other comprehensive income	(204		)					3,555
TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY	$	1,055,611						$	1,117,831
Impact of noninterest bearing sources and other changes in balance sheet composition						0.15	%						0.21	%
Net interest margin						2.38	%						2.44	%

__________________


(1)	Nonaccrual loans have been included in the average balance. Only the interest collected on such loans has been included as income.

(2)

Interest income from securities includes the effects of taxable-equivalent adjustments using a federal income tax rate of approximately 34% for both years reported and where applicable, state income taxes, to increase tax-exempt interest income to a taxable-equivalent basis. The net taxable equivalent adjustment amounts included in the above table were $419 thousand and $439 thousand for the years ended September 30, 2013 and 2012, respectively.

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CHANGE IN INTEREST INCOME AND EXPENSE ON A TAX EQUIVALENT BASIS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2013 COMPARED TO 2012



	Increase (Decrease) in Interest Income and Expense Due to Changes in:
	Volume			Rate			Total
	(in thousands)
Interest earning assets:
Loans, net of unearned income	$	(1,982	)	$	(2,770	)	$	(4,752	)
Securities – taxable	710			(354		)	356
Securities – non-taxable	61			(109		)	(48		)
Other earning assets	(142		)	93			(49		)
Total earning assets	(1,353		)	(3,140		)	(4,493		)
Interest bearing liabilities:
Interest bearing demand deposits	68			17			85
Money market accounts	136			(309		)	(173		)
Savings deposits	—			(30		)	(30		)
Time deposits of less than $100 thousand	(123		)	(389		)	(512		)
Time deposits of $100 thousand or more	(18		)	(372		)	(390		)
Brokered CDs and CDARS^®	(1,823		)	158			(1,665		)
Repurchase agreements	(39		)	(256		)	(295		)
Other borrowings	(1		)	—			(1		)
Total interest bearing liabilities	(1,800		)	(1,181		)	(2,981		)
Increase (decrease) in net interest income	$	447		$	(1,959	)	$	(1,512	)

Net Interest Income – Volume and Rate Changes

Interest income for the three and nine months ended September 30, 2013 was $8.2 million and $23.8 million, respectively, a 8.9% and 15.9% decrease, respectively, compared to the same periods in 2012. Average earning assets decreased $107.0 million, or 10.3%, in the third quarter of 2013 compared to the same period in 2012, and decreased $57.5 million, or 5.6%, for the nine months ended September 30, 2013. As compared to the third quarter of 2012, average loans declined in the third quarter of 2013 by $63.8 million, offset by a $75.0 million increase in investment securities and a $118.3 million decrease in other earning assets. The change in mix and volume of earning assets decreased interest income by $445 thousand and $1.4 million, respectively, comparing the three and nine months of 2013 to the same periods in 2012. For other earning assets, we maintained an elevated balance at the Federal Reserve Bank of Atlanta, which averaged approximately $86.6 million and $134.3 million, respectively, for the three and nine months ended September 30, 2013. The yield on this account is approximately 0.25%. The purpose of maintaining an elevated balance in liquid assets is to reduce liquidity risk resulting from deteriorating asset quality and the Order. Additional details relating to liquidity risk is provided below in "Liquidity." We anticipate average loans to grow over the next year as previously discussed in the strategic initiatives section. We anticipate average earning assets to remain consistent for the remainder of 2013.

The tax equivalent yield on earning assets decreased by 0.07% and 0.40% for the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. The yield on loans declined by 0.34% to 4.84% and declined 0.65% to 4.80% for the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012. We anticipate the yield on loans to remain consistent or decline slightly over the balance of 2013 as we continue to operate in a competitive lending environment and we have invested approximately $50.3 million in government guaranteed loans. We anticipate that the yield on investment securities for the fourth quarter of 2013 will be consistent with the yield for third quarter 2013 and lower than the comparable 2012 period due to the changes in bond prices year-over-year. We are

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maintaining an asset-sensitive balance sheet and will benefit from an eventual increase in the federal funds rate. As of September 30, 2013, approximately 31.8% of our loan portfolio is either variable or adjustable rate. The variable rate loans reprice simultaneously with changes in the associated index, such as the Prime, LIBOR or Treasury bond rates, while the repricing of adjustable rate loans are based on a time component in addition to changes in the associated index. Accordingly, changes in the target federal funds rate have an immediate impact on the yield of our earning assets.

Total interest expense was $2.0 million and $6.9 million for the three and nine months ended September 30, 2013, respectively, or 35.8% lower and 30.2% lower, respectively, than the same periods in 2012. Average interest bearing liabilities decreased by $100.5 million and $42.0 million for the three and nine month periods ended September 30, 2013, respectively, compared to the same periods in 2012. Comparing the third quarter of 2013 to the same period in 2012, average brokered deposits declined by $102.9 million while retail certificates of deposits declined by $34.0 million and jumbo certificates of deposit decreased $24.0 million. Comparing the nine months ended September 30, 2013 to the same period in 2012, average brokered deposits declined by $79.7 million while retail certificates of deposit decreased $14.5 million and jumbo certificates of deposit decreased by $1.8 million. The reductions in volume reduced interest expense by $966 thousand and $1.8 million for the three and nine month periods ended September 30, 2013, respectively. Further reducing interest expense $153 thousand and $1.2 million for the three and nine month periods ended September 30, 2013, respectively, was the decline in rates paid on interest bearing liabilities, primarily in money market and retail and jumbo certificates of deposits. The decrease in rates is due primarily to term deposits maturing and repricing at lower current market rates.

We expect average earning assets to stabilize through the remainder of 2013 as loan volume improves and investment securities increase through the reallocation of our excess cash reserves into higher yielding assets. We expect average brokered deposits to decline through the remainder of 2013 while all other interest bearing liabilities are expected to increase compared to 2012 levels. Rates paid on deposits are expected to continue to decline compared to 2012 rates as higher cost brokered CDs mature and are replaced with lower rate core deposits or funded from our excess liquidity.

Net Interest Income – Net Interest Spread and Net Interest Margin

The banking industry uses two key ratios to measure 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.

Our net interest rate spread (on a tax equivalent basis) was 2.56% and 2.23% for the three and nine months ended September 30, 2013, respectively, compared to 2.10% and 2.23%, respectively, for the same periods in 2012. Our net interest margin (on a tax equivalent basis) was 2.71% and 2.38% for the three and nine months ended September 30, 2013, respectively, compared to 2.30% and 2.44%, respectively, for the same periods in 2012. The increase in the net interest spread and net interest margin comparing 2013 to 2012 was primarily due to reductions in our cost of deposits as well as the deployment of cash into higher yielding investment securities. Noninterest bearing deposits contributed 15 and 15 basis points to the margin during the three and nine months ended September 30, 2013, respectively, and 20 and 21 basis points for both the three and nine month period ended September 30, 2012, respectively.

In prior years, we terminated two sets of interest rate swaps. The combined gains at termination were $7.8 million and were accreted into interest income over the remaining life of the originally hedged items. The interest rate swaps were fully accreted as of December 31, 2012. For the three and nine months ended September 30, 2012, the accretion of the swaps added approximately $410 thousand and $1.3 million, respectively, to interest income.

We currently anticipate our net interest spread and net interest margin to continue improving during the remainder of 2013 and into 2014. However, improvement is dependent on multiple factors including our ability to grow loans, raise core deposits, maturities of brokered deposits, our deposit and loan pricing, and any possible further action by the Federal Reserve Board to adjust the target federal funds rate.

Provision for Loan and Lease Losses

The provision for loan and lease losses during the three and nine month periods ended September 30, 2013 was a credit, or negative provision, of $1.6 million and $1.8 million, respectively, compared to charges against income of $4.5 million and $10.5 million, respectively, for the same periods in 2012. Net charge-offs (recoveries) for the three and nine months ended September 30, 2013 were $(32) thousand and $1.3 million, respectively, compared to net charge-offs of $6.7 million and $12.6 million, respectively, for the same periods in 2012. Annualized net charge-offs as a percentage of average loans were 0.32% for the nine months ended September 30, 2013 compared to 2.82% for the same period in 2012. Our peer group’s average

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annualized net charge-offs as a percentage of average loans for the nine months ended September 30, 2013 (as reported in the September 30, 2013 Uniform Bank Performance Report) were 0.27%.

The decrease in our provision for loan and lease losses for the three and nine months of 2013 compared to the same periods in 2012 resulted from our analysis of probable incurred losses in the loan portfolio in relation to the reduction of our portfolio, the reduction in the amount of nonperforming loans, as well as improving general economic conditions. As of September 30, 2013, specific reserves for impaired loans totaled zero compared to $50 thousand as of December 31, 2012 and $98 thousand as of September 30, 2012. At September 30, 2013, due to less charge-offs and fewer non-performing loans, our ratio of the allowance to total loans was 2.00% compared to 2.55% at December 31, 2012 and 3.05% at September 30, 2012.

As of September 30, 2013, management determined our allowance of $10.7 million was adequate to provide for probable incurred credit losses, which we describe more fully below in the Allowance for Loan and Lease Losses section. We analyze the allowance on at least a quarterly basis, and the next review will be at December 31, 2013, or sooner if needed; the provision expense will be adjusted accordingly, if necessary.

We will continue to provide provision expense as necessary to maintain an allowance level adequate to absorb known and probable incurred losses inherent in our loan portfolio. As the determination of provision expense, or reversal, is a function of the adequacy of the allowance for loan and lease losses, we cannot reasonably estimate the provision impact for the remainder of 2013. Furthermore, the provision expense could materially increase or decrease in 2013 depending on a number of factors, including, among others, the level of net charge-offs, the amount of classified loans and the value of collateral associated with impaired loans.

Noninterest Income

Noninterest income totaled $2.5 million and $7.3 million for the three and nine months ended September 30, 2013, a decrease of $180 thousand, or 6.7%, and increase of $266 thousand, or 3.8%, respectively, from the same periods in 2012. The quarterly decrease and year-over-year increase is primarily a result of mortgage banking income and net gains from sales of securities available for sale.

The following table presents the components of noninterest income for the three and nine month periods ended September 30, 2013 and 2012.

NONINTEREST INCOME



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013		Percent Change		2012		2013		Percent Change		2012
	(in thousands, except percentages)
Service charges on deposit accounts	798		10.1	%	725		2,298		6.4	%	2,160
Point-of-sale (POS) fees	401		18.3	%	339		1,171		13.4	%	1,033
Bank-owned life insurance income	237		(32.7	)%	352		720		(7.5	)%	778
Mortgage banking income	420		68.7	%	249		927		29.1	%	718
Net gains on sales of securities available-for-sale	—		(100.0	)%	143		154		6.9	%	144
Gains on sales of other real estate	187		(62.4	)%	497		640		(19.8	)%	798
Other income	471		21.1	%	389		1,345		(1.0	)%	1,358
Total noninterest income	$	2,514	(6.7	)%	$	2,694	$	7,255	3.8	%	$	6,989

Our largest sources of noninterest income are service charges and fees on deposit accounts. Total service charges, including NSF fees, were $798 thousand and $2.3 million for the three and nine months ended September 30, 2013, an increase of $73 thousand, or 10.1%, and an increase of $138 thousand, or 6.4%, respectively, from the same periods in 2012. While service charges and fees on deposit accounts typically correspond to the level and mix of our customer deposits, the continued implementation of the Dodd-Frank financial reform legislation may directly or indirectly impact the fee structure of our deposit products; therefore, we cannot reasonably estimate deposit fees for future periods.

Point-of-sale fees increased 18.3% to $401 thousand and increased 13.4% to $1.2 million, respectively, for the three and nine months ended September 30, 2013 compared to the same periods in 2012. POS fees are primarily generated when our customers use their debit cards for retail purchases. We anticipate POS fees to continue to grow as customer trends show increased use of debit cards, although it is unclear if certain provisions affecting interchange fees for card issuers included in the Dodd-Frank financial reform legislation will have a future material impact on this product and its revenue.

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Bank-owned life insurance income was $237 thousand and $720 thousand for the three and nine month period ended September 30, 2013, a decrease of $115 thousand or 32.7% and a decrease of $58 thousand or 7.5%, respectively, from 2012 levels. The Company is the owner and beneficiary of these contracts. The income generated by the cash value of the insurance policies accumulates on a tax-deferred basis and is tax-free to maturity. In addition, the insurance death benefit will be a tax-free payment to the Company. On a fully tax-equivalent basis, the weighted average interest rate earned on the policies was approximately 4.54% for the nine months ended September 30, 2013.

Mortgage banking income for the three and nine months ended September 30, 2013 increased $171 thousand, or 68.7%, and increased $209 thousand, or 29.1%, respectively, to $420 thousand and $927 thousand, respectively, compared to $249 thousand and $718 thousand, respectively, in the same periods of 2012. As discussed in the notes to our consolidated financial statements, we elected the fair value option for all held for sale loan originations. This election impacts the timing and recognition of origination fees and costs, as well as the value of servicing rights. The recognition of the income and fees is concurrent with the origination of the loan.

Net gains on sales of securities available-for-sale for the three and nine months ended September 30, 2013 decreased $143 thousand to zero and increased $10 thousand to $154 thousand, respectively when compared to the same periods in 2012.

Gains on sales of other real estate for the three and nine months ended September 30, 2013 decreased $310 thousand and $158 thousand, respectively, to $187 thousand and $640 thousand, respectively, compared to $497 thousand and $798 thousand, respectively, in the same periods of 2012. These gains are a result of our continued efforts to reduce the balance of other real estate owned and the sale price of the property versus the carrying value which included write-downs taken in previous periods.

Our process to originate and sell a conforming mortgage in the secondary market typically takes 30 to 60 days from the date of mortgage origination to the date the mortgage is sold to an investor in the secondary market. Due to the normal processing time, we will have a certain amount of held for sale loans at any time. Mortgages originated for sale in the secondary market totaled $51.1 million, $45.3 million and $33.8 million as of September 30, 2013, December 31, 2012 and September 30, 2012, respectively. Mortgages sold in the secondary market totaled $38.6 million, $43.9 million and $33.4 million as of September 30, 2013, December 31, 2012 and September 30, 2012, respectively. We sold these loans with the right to service the loan being released to the purchaser for a fee. Mortgage income for the remainder of the year is dependent on mortgage rates as well as our ability to generate higher levels of held for sale loans.

Other income for the three and nine months ended September 30, 2013 was $471 thousand and $1.3 million, respectively, compared to $389 thousand and $1.4 million for the same periods in 2012. The components of other income primarily consist of ATM fee income, trust fee income, underwriting revenue, safe deposit box fee income, repossessions, leased equipment and premises and equipment.

Noninterest Expense

Noninterest expense decreased $1.4 million and increased $1.1 million, or 10.7% and 2.9%, to $11.4 million and $38.4 million for the three and nine months ended September 30, 2013, respectively, compared to $12.8 million and $37.3 million for the same periods in 2012. Total noninterest expense decreased for the three months ended September 30, 2013, primarily due to decreases in regulatory assessments and a decrease in asset quality charges partially offset by an increase in salaries. Total noninterest expense increased for the nine months ended September 30, 2013, mostly due to salary and benefit cost and professional fees partially offset by lower asset quality charges.

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The following table represents the components of noninterest expense for the three and nine month periods ended September 30, 2013 and 2012.

NONINTEREST EXPENSE



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2013		Percent Change		2012		2013		Percent Change		2012
	(in thousands, except percentages)
Salaries & benefits	$	5,807	10.1	%	$	5,275	$	17,081	14.6	%	$	14,911
Occupancy	891		54.7	%	576		2,502		5.8	%	2,364
Furniture and equipment	656		48.8	%	441		1,799		17.2	%	1,535
Professional fees	839		5.4	%	796		3,823		44.8	%	2,641
FDIC insurance	150		(80.0	)%	750		2,150		3.5	%	2,077
Write-downs on OREO and repossessions	374		(71.5	)%	1,314		1,997		(55.6	)%	4,500
Losses on other real estate owned, repossessions and fixed assets	46		(61.7	)%	120		206		(72.5	)%	749
Non-performing asset expenses	165		(67.2	)%	503		1,440		(5.0	)%	1,516
Data processing	305		(58.1	)%	728		978		(37.7	)%	1,571
Communications	121		(6.2	)%	129		331		(11.7	)%	375
ATM/Debit Card fees	144		4.3	%	138		476		26.6	%	376
Intangible asset amortization	67		(28.0	)%	93		213		(30.2	)%	305
Printing & supplies	116		1.8	%	114		288		(23.0	)%	374
Advertising	89		(3.3	)%	92		246		13.4	%	217
Insurance	523		22.8	%	426		1,873		80.4	%	1,038
OCC Assessments	125		(1.6	)%	127		376		(0.3	)%	377
Other expense	1,001		(13.6	)%	1,159		2,593		10.2	%	2,354
Total noninterest expense	$	11,419	(10.7	)%	$	12,781	$	38,372	2.9	%	$	37,280

Salaries and benefits for the three and nine months ended September 30, 2013 increased $532 thousand and $2.2 million, respectively, or 10.1% and 14.6%, respectively, compared to the same periods in 2012. The increase in salaries and benefits is primarily related to employees hired during late 2012 and early 2013, partially offset by retirements and resignations during 2012. As of September 30, 2013, we had 30 full-service banking offices with 313 full-time equivalent employees. As of September 30, 2012, we had 30 full-service banking offices with 328 full-time equivalent employees.

Occupancy expense increased $315 thousand and $138 thousand, or 54.7% and 5.8% for the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012, primarily the result of adjustments to lease expenses. As of September 30, 2013, First Security leased six facilities and the land for three branches. As a result, current period occupancy expense is higher than if we owned these facilities, including the real estate, but conversely, we have been able to deploy the capital into earning assets rather than capital expenditures for facilities.

Professional fees increased $43 thousand and increased $1.2 million for the three and nine months ended September 30, 2013 compared to the same period in 2012. The increase is primarily due to an increase in marketing expense related to our new logo and branch re-branding, as well as an increase in directors fees compared to 2012. Professional fees include fees related to investor relations, outsourcing compliance and a portion of internal audit, as well as external audit, tax services and legal and accounting advice related to, among other things, foreclosures, lending activities, employee benefit programs and regulatory matters.

FDIC deposit premium insurance decreased $600 thousand to $150 thousand and increased $73 thousand to $2.2 million, respectively, for the three and nine months ended September 30, 2013 compared to the same periods in 2012. The decrease is a direct result of the bank's improved operating condition at September 30, 2013.

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Insurance expense increased $97 thousand to $523 thousand and increased $835 thousand to $1.9 million for the three and nine months ended September 30, 2013, compared to the same periods in 2012. In connection with the Recapitalization, we elected to convert our existing D&O insurance policies into seven-year tail policies and entered into new ongoing D&O policies. The conversion expedited the remaining expense on the existing policies to be recognized into current earnings. We expect significant reductions in insurance expense for the remainder of 2013 and into 2014 based on the improved capital position.

At foreclosure or repossession, the fair value of the OREO property or repossession is determined and a charge-off to the allowance is recorded, if applicable. The fair value is generally determined based the valuation of a third-party appraisal, discounted by our historical realization rate as well as a cost-to-sell factor. The discount and cost-to-sell factor are monitored and re-assessed, if necessary, on a quarterly basis. An increase to the discount factor may result in additional write-downs to some or all of our properties. Any decreases in value subsequent to the initial determination of fair value are recorded as a write-down. As a general policy, we re-assess the fair value of OREO and repossessions on at least an annual basis or sooner if there are indicators that deterioration in value has occurred. Write-downs are based on property-specific appraisals or valuations. Write-downs on OREO and repossessions decreased $940 thousand, or 71.5%, and decreased $2.5 million, or 55.6%, respectively, for the three and nine month period ended September 30, 2013 compared to the same periods in 2012. Write-downs for the remainder of 2013 are dependent on multiple factors, including, but not limited to, the assumptions used by the independent appraisers, real estate market conditions, and our ability to liquidate properties.

Losses on OREO, repossessions and fixed assets decreased $74 thousand to $46 thousand, or 61.7%, and decreased $543 thousand to $206 thousand, or 72.5%, respectively, for the three and nine month periods ended September 30, 2013, compared to the same periods in 2012. As discussed above, we continue to monitor our fair value assumptions and recognize additional write-downs when appropriate. Generally, gains and losses on the sale of OREO should be minimized by our fair value assumptions applied to OREO, as discussed above.

Non-performing asset expenses include, among other items, maintenance, repairs, utilities, taxes and storage costs. These costs decreased $338 thousand, or 67.2%, and $76 thousand, or 5.0%, respectively, for the three and nine months ended September 30, 2013 compared to the same periods in 2012. We anticipate significant reductions in this category for the remainder of 2013.

Data processing fees decreased 58.1% and 37.7%, respectively, for the three and nine month periods ended September 30, 2013 compared to the same periods in 2012. During the third quarter of 2012, we completed a core systems conversion and are beginning to see a reduction in expense related to the conversion.

Intangible asset amortization expense declined $26 thousand, or 28.0% and $92 thousand, or 30.2% for the three and nine month periods ended September 30, 2013 compared to the same periods in 2012. Our core deposit intangible assets amortize on an accelerated basis in which the expense recognized declines over the estimated useful life of ten years. We anticipate slight decreases in amortization expense throughout the remainder of 2013.

Other expense decreased $158 thousand and increased $239 thousand, respectively, for the three and nine months ended September 30, 2013, respectively, compared to the same periods in 2012.

Income Taxes

We recorded an income tax provision of $322 thousand and $358 thousand, respectively, for the three and nine month period ended September 30, 2013 compared to an income tax provision of $108 thousand and a tax benefit of $402 thousand, respectively, for the same periods in 2012. For the nine months ended September 30, 2013, we recorded $5.8 million in additional deferred tax valuation allowance to offset the tax benefits generated during the first two quarters of 2013.

At September 30, 2013, we evaluated our significant uncertain tax positions. Under the “more-likely-than-not” threshold guidelines, we believe we have identified all significant uncertain tax benefits. We evaluate, on a quarterly basis or sooner if necessary, to determine if new or pre-existing uncertain tax positions are significant. In the event a significant uncertain tax position is determined to exist, penalty and interest will be recorded as a component of income tax expense in our consolidated financial statements. With the resolution of our primary uncertain tax position, as described above, we have not identified any additional significant uncertain tax positions.

A valuation allowance is required when it is “more likely than not” that the deferred tax assets will not be realized. The evaluation requires significant judgment and extensive analysis of all available positive and negative evidence, the forecasts of future income, applicable tax planning strategies and assessments of the current and future economic and business conditions. We identified as positive evidence the existence of taxes paid in available carryback years. Negative evidence included a cumulative loss in recent years as well as current business trends. As conditions change, we will evaluate the need to increase or decrease the valuation allowance. Currently, we anticipate increasing the valuation allowance to offset any future recorded tax

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benefit to result in minimal, if any, income tax expense or benefit. As business and economic conditions change, we will re-evaluate the valuation allowance.

On October 30, 2012, the Company adopted a Tax Benefits Preservation Plan (the "NOL Rights Plan") and declared a dividend of one preferred stock purchase right (each a “Right” and collectively, the “Rights”) for each outstanding share of the Company's common stock, payable to holders of record as of the close of business on November 12, 2012 (the “Record Date”). Each Right entitles the registered holder to purchase from the Company one one-thousandth of one share of Series B Participating Preferred Stock, no par value, of the Company (the “Series B Preferred Stock”), at a purchase price equal to $20.00 per one one-thousandth of a share, subject to adjustment (the “Rights or Series B Purchase Price”). The description and terms of the Rights are set forth in the NOL Rights Plan, dated October 30, 2012, as the same may be amended from time to time, between the Company and Registrar and Transfer Company, as Rights Agent.

Purpose of the NOL Rights Plan

The Company has previously experienced substantial net operating losses, which it may carryforward in certain circumstances to offset current and future taxable income and thus reduce its federal income tax liability, subject to certain requirements and restrictions. The purpose of the NOL Rights Plan is to help preserve the value of the Company's deferred tax assets, such as its net operating losses (“Tax Benefits”), for U.S. federal income tax purposes.

These Tax Benefits can be valuable to the Company. However, if the Company experiences an “ownership change,” as defined in Section 382 (“Section 382”) of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder, its ability to use the Tax Benefits could be substantially limited and/or delayed, which would significantly impair the value of the Tax Benefits. Generally, the Company would experience an “ownership change” under Section 382 if one or more “5 percent shareholders” increase their aggregate percentage ownership by more than 50 percentage points over the lowest percentage of stock owned by such shareholders over the preceding three-year period. As a result, the Company has utilized a 5% “trigger” threshold in the NOL Rights Plan that is intended to act as a deterrent to any person or entity seeking to acquire 5% or more of the outstanding Common Stock without the prior approval of the Board.

On October 30, 2012, in connection with the adoption of the NOL Rights Plan, the Company filed Articles of Amendment to the Charter of Incorporation (the “Articles Amendment”) with the Secretary of State of the State of Tennessee. Further details about the Plan and the Articles Amendment can be found in Exhibits 3.1 and 4.1 to the Current Report on Form 8-K filed with the SEC on October 30, 2012.

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FINANCIAL CONDITION

As of September 30, 2013, we had total consolidated assets of $1.0 billion, total loans of $534.6 million, total deposits of $909.8 million and shareholders’ equity of $83.4 million. As of December 31, 2012, we had total consolidated assets of $1.1 billion, total loans of $541.1 million, total deposits of $1.0 billion and shareholders' equity of $29.1 million. As of September 30, 2012, we had total assets of $1.1 billion, total loans of $573.4 million, total deposits of $1.0 billion and shareholders' equity of $44.7 million.

Loans

The effects of the economic recession, as well as our active efforts to reduce certain credit exposures and their related balance sheet risk, resulted in declining loan balances since September 30, 2011. Certain strategic initiatives, as discussed in the Strategic Initiatives for 2013 section of MD&A above, have partially mitigated the decrease in loans for the first nine months in 2013. As of September 30, 2013, total loans decreased by $6.5 million, or 1.2% (1.6% annualized), from December 31, 2012 and decreased by $38.7 million, or 6.8%, from September 30, 2012.

The following table presents our loan portfolio by type.

LOAN PORTFOLIO



										Percent change from
	September 30, 2013			December 31, 2012			September 30, 2012			December 31, 2012		September 30, 2012
	(in thousands, except percentages)
Loans secured by real estate –
Residential 1-4 family	$	173,446		$	188,191		$	200,566		(7.8	)%	(13.5	)%
Commercial	222,603			221,655			232,470			0.4	%	(4.2	)%
Construction	42,364			33,407			37,744			26.8	%	12.2	%
Multi-family and farmland	18,844			17,051			24,075			10.5	%	(21.7	)%
	457,257			460,304			494,855			(0.7	)%	(7.6	)%
Commercial loans	50,879			61,398			58,045			(17.1	)%	(12.3	)%
Consumer installment loans	21,586			13,387			14,757			61.2	%	46.3	%
Leases, net of unearned income	42			568			771			(92.6	)%	(94.6	)%
Other	4,863			5,473			4,937			(11.1	)%	(1.5	)%
Total loans	534,627			541,130			573,365			(1.2	)%	(6.8	)%
Allowance for loan and lease losses	(10,700		)	(13,800		)	(17,490		)	(22.5	)%	(38.8	)%
Net loans	$	523,927		$	527,330		$	555,875		(0.6	)%	(5.7	)%

Loans year-to-date have remained consistent with a decrease of approximately $6.5 million. This is mostly due to an increase in construction real estate and consumer installment loans of $9.0 million, or 26.8%, and $8.2 million or 61.2%, respectively, offset by decreases in residential 1-4 family real estate loans of $14.7 million, or 7.8% and commercial and industrial loans of $10.5 million, or 17.1%.

Comparing September 30, 2013 to September 30, 2012, loans decreased by $38.7 million, or 6.8%. The largest declining loan balances were residential 1-4 family loans of $27.1 million, a decrease of 13.5%, commercial real estate loans of $9.9 million, or 4.2%,multi-family and farmland loans of $5.2 million, a decrease of 21.7% and commercial and industrial loans of $7.2 million, a decrease of 12.3%.

As we develop and implement lending initiatives, we will focus on extending prudent loans to creditworthy consumers and businesses. We anticipate our loan portfolio to start growing during the last quarter of 2013 and into 2014. Funding of future loans may be restricted by our ability to raise core deposits, although we may use current cash reserves, as necessary and appropriate. Loan growth may also be restricted by the necessity for us to maintain appropriate capital levels.

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Allowance for Loan and Lease Losses

The allowance for loan and lease losses reflects our assessment and estimate of the risks associated with extending credit and our evaluation of the quality of the loan portfolio. We regularly analyze our loan portfolio in an effort to establish an allowance that we believe will be adequate in light of anticipated risks and loan losses. In assessing the adequacy of the allowance, we review the size, quality and risk of loans in the portfolio. We also consider such factors as:


•	our loan loss experience;


•	specific known risks;


•	the status and amount of past due and non-performing assets;


•	underlying estimated values of collateral securing loans;


•	current and anticipated economic conditions; and


•	other factors which we believe affect the allowance for potential credit losses.

The allowance is composed of two primary components: (1) specific impairments for substandard/nonaccrual loans and leases and (2) general allocations for classified loan pools, including special mention and substandard/nonaccrual loans, as well as general allocations for the remaining pools of loans. We accumulate pools based on the underlying classification of the collateral. Each pool is assigned a loss severity rate based on historical loss experience and various qualitative and environmental factors, including, but not limited to, credit quality and economic conditions.

The following loan portfolio segments have been identified: (1) Real estate: Residential 1-4 family, (2) Real estate: Commercial, (3) Real estate: Construction, (4) Real estate: Multi-family and farmland, (5) Commercial, (6) Consumer, (7) Leases and (8) Other. We evaluate the risks associated with these segments based upon specific characteristics associated with the loan segments. The risk associated with the Real estate: Construction portfolio is most directly tied to the probability of declines in value of the residential and commercial real estate in our market area and secondarily to the financial capacity of the borrower. The risk associated with the Real estate: Commercial portfolio is most directly tied to the lease rates and occupancy rates for commercial real estate in our market area and secondarily to the financial capacity of the borrower. The other portfolio segments have various risk characteristics, including, but not limited to: the borrower’s cash flow, the value of the underlying collateral, and the capacity of guarantors.

An analysis of the credit quality of the loan portfolio and the adequacy of the allowance for loan and lease losses is prepared jointly by our accounting and credit administration departments and presented to our Board of Directors or the Directors’ Loan Committee on at least a quarterly basis. Based on our analysis, we may determine that our future provision expense needs to increase or decrease in order for us to remain adequately reserved for probable, incurred loan losses. As stated earlier, we make this determination after considering both quantitative and qualitative factors under appropriate regulatory and accounting guidelines.

Our allowance for loan and lease losses is also subject to regulatory examinations and determinations as to adequacy, which may take into account such factors as the methodology used to calculate the allowance and the size of the allowance compared to a group of peer banks. During their routine examinations of banks, the regulators may require a bank to make additional provisions to its allowance for loan losses when, in the opinion of the regulators, their credit evaluations and allowance methodology differ materially from the bank’s methodology. We believe our allowance methodology is in compliance with regulatory inter-agency guidance as well as applicable GAAP guidance.

While it is our policy to charge-off all or a portion of certain loans in the current period when a loss is considered probable, there are additional risks of future losses that cannot be quantified precisely or attributed to particular loans or classes of loans. Because the assessment of these risks includes assumptions regarding local and national economic conditions, our judgment as to the adequacy of the allowance may change from our original estimates as more information becomes available and events change.

Allowance—Loan Pools

As indicated in the Allowance—Overview above, we analyze our allowance by segregating our portfolio into two primary categories: impaired loans and non-impaired loans. Impaired loans are individually evaluated, as further discussed below. Non-impaired loans are segregated first by loan risk rating and then into homogeneous pools based on loan type, collateral or purpose of proceeds. We believe our loan pools conform to regulatory and accounting guidelines.

Impaired loans generally include those loan relationships in excess of $500 thousand with a risk rating of substandard/nonaccrual or doubtful. For these loans, we determine the impairment based upon one of the following methods: (1) discounted cash flows, (2) observable market pricing or (3) the fair value of the collateral. The amount of the estimated loss, if any, is then specifically reserved in a separate component of the allowance unless the relationship is considered collateral dependent, in which case the estimated loss is charged-off in the current period.

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For non-impaired loans, we first segregate special mention and non-impaired substandard loans into two distinct pools. All remaining loans are further segregated into homogeneous pools based on loan type, collateral or purpose of proceeds. Each of these pools is evaluated individually and is assigned a loss factor based on our best estimate of the loss that potentially could be realized in that pool of loans. The loss factor is the sum of an objectively calculated historical loss percentage and a subjectively calculated risk percentage. The actual annual historical loss factor is typically a weighted average of each period’s loss. For the historical loss factor, we utilize a migration loss analysis. Each period may be assigned a different weight depending on certain trends and circumstances. The subjectively calculated risk percentage is the sum of eight qualitative and environmental risk categories. These categories are evaluated separately for each pool. The eight risk categories are: (1) underlying collateral value, (2) lending practices and policies, (3) local and national economies, (4) portfolio volume and nature, (5) staff experience, (6) credit quality, (7) loan review and (8) competition, regulatory and legal issues.

Allowance—Loan Risk Ratings

A consistent and appropriate loan risk rating methodology is a critical component of the allowance. We classify loans as: pass, special mention, substandard/impaired, substandard/non-impaired, doubtful or loss. The following describes our loan classifications and the various risk indicators associated with each risk rating.

Loans to Businesses:


•	Downward trend in sales, profit levels and margins


•	Impaired working capital position compared to industry


•	Cash flow strained in order to meet debt repayment schedule


•	Technical defaults due to noncompliance with financial covenants


•	Recurring trade payable slowness


•	High leverage compared to industry average with shrinking equity cushion


•	Questionable abilities of management


•	Weak industry conditions


•	Inadequate or outdated financial statements

Loans to Businesses or Individuals:


•	Loan delinquencies and overdrafts may occur


•	Original source of repayment questionable


•	Documentation deficiencies may not be easily correctable


•	Loan may need to be restructured


•	Collateral or guarantor offers adequate protection


•	Unsecured debt to tangible net worth is excessive

A substandard loan risk rating is characterized as having specifically identified weaknesses and deficiencies typically resulting from severe adverse trends of a financial, economic, or managerial nature, and may warrant non-accrual status. Substandard loans have a greater likelihood of loss and may require a protracted work-out plan. Substandard/impaired loans are relationships in excess of $500 thousand and are individually reviewed. In addition to the factors listed for special mention loans, substandard loans may be characterized by the following risks and/or trends:

Loans to Businesses:


•	Sustained losses that have severely eroded equity and cash flows


•	Concentration in illiquid assets


•	Serious management problems or internal fraud


•	Chronic trade payable slowness; may be placed on COD or collection by trade creditor


•	Inability to access other funding sources


•	Financial statements with adverse opinion or disclaimer; may be received late


•	Insufficient documented cash flows to meet contractual debt service requirements

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Loans to Businesses or Individuals:


•	Chronic or severe delinquency or has met the retail classification standards which is generally past dues greater than 90 days


•	Frequent overdrafts


•	Likelihood of bankruptcy exists


•	Serious documentation deficiencies


•	Reliance on secondary sources of repayment which are presently considered adequate


•	Demand letter sent


•	Litigation may have been filed against the borrower

Loans with a risk rating of doubtful are individually analyzed to determine our best estimate of the loss based on the most recent assessment of all available sources of repayment. Doubtful loans are considered impaired and placed on nonaccrual. For doubtful loans, the collection or liquidation in full of principal and/or interest is highly questionable or improbable. We estimate the specific potential loss based upon an individual analysis of the relationship risks, the borrower’s cash flow, the borrower’s management and any underlying secondary sources of repayment. The amount of the estimated loss, if any, is then either specifically reserved in a separate component of the allowance or charged-off. In addition to the characteristics listed for substandard loans, the following characteristics apply to doubtful loans:

Loans to Businesses:


•	Normal operations are severely diminished or have ceased


•	Seriously impaired cash flow


•	Numerous exceptions to loan agreement


•	Outside accountant questions entity’s survivability as a “going concern”


•	Financial statements may be received late, if at all


•	Material legal judgments filed


•	Collection of principal and interest is impaired


•	Collateral/Guarantor may offer inadequate protection

Loans to Businesses or Individuals:


•	Original repayment terms materially altered


•	Secondary source of repayment is inadequate


•	Asset liquidation may be in process with all efforts directed at debt retirement


•	Documentation deficiencies not correctable

The consistent application of the above loan risk rating methodology ensures we have the ability to track historical losses and appropriately estimate potential future losses in our allowance. Additionally, appropriate loan risk ratings assist us in allocating credit and special asset personnel in the most effective manner. Significant changes in loan risk ratings can have a material impact on the allowance and thus a material impact on our financial results by requiring significant increases or decreases in provision expense.

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The following table presents an analysis of the changes in the allowance for loan and lease losses for the nine months ended September 30, 2013 and 2012. The provision for loan and lease losses in the table below does not include our provision for losses on unfunded commitments of $18 thousand and $18 thousand for the nine month periods ended September 30, 2013 and 2012, respectively. The reserve for unfunded commitments totaled $276 thousand and $252 thousand as of September 30, 2013 and 2012, respectively, and is included in other liabilities in the accompanying consolidated balance sheets.

ANALYSIS OF CHANGES IN ALLOWANCE FOR LOAN AND LEASE LOSSES



	For the Nine Months Ended
	September 30,
	2013			2012
	(in thousands, except percentages)
Allowance for loan and lease losses –
Beginning of period	$	13,800		$	19,600
(Credit) Provision for loan and lease losses	(1,780		)	10,492
Sub-total	12,020			30,092
Charged-off loans:
Real estate – residential 1-4 family	1,324			2,532
Real estate – commercial	531			3,930
Real estate – construction	503			5,246
Real estate – multi-family and farmland	36			28
Commercial loans	31			2,659
Consumer installment and other loans	460			307
Leases, net of unearned income	—			864
Other loans				—
Total charged-off	2,885			15,566
Recoveries of charged-off loans:
Real estate – residential 1-4 family	281			145
Real estate – commercial	313			116
Real estate – construction	312			991
Real estate – multi-family and farmland	15			9
Commercial loans	218			340
Consumer installment and other loans	289			486
Leases, net of unearned income	133			877
Other	4			—
Total recoveries	1,565			2,964
Net charged-off loans	1,320			12,602
Allowance for loan and lease losses – end of period	$	10,700		$	17,490
Total loans – end of period	$	534,627		$	573,365
Average loans	$	544,136		$	595,278
Net loans charged-off to average loans, annualized	0.32		%	2.83		%
Provision (credit) for loan and lease losses to average loans, annualized	(0.44		)%	2.36		%
Allowance for loan and lease losses as a percentage of:
Period end loans	2.00		%	3.05		%
Nonperforming loans	146.33		%	50.22		%

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The following table presents the allocation of the allowance for loan and lease losses for each respective loan category with the corresponding percentage of loans in each category to total loans. The comprehensive allowance analysis developed by our financial reporting and credit administration group enables us to allocate the allowance based on risk elements within the portfolio.

ALLOCATION OF THE ALLOWANCE FOR LOAN AND LEASE LOSSES



	As of September 30, 2013				As of December 31, 2012				As of September 30, 2012
	Amount		Percent of Portfolio¹		Amount		Percent of Portfolio¹		Amount		Percent of Portfolio¹
	(in thousands, except percentages)
Real estate – residential 1-4 family	$	4,234	32.4	%	$	6,207	34.8	%	$	6,794	35.4	%
Real estate – commercial	2,875		41.6	%	3,736		41.0	%	4,663		40.3	%
Real estate – construction	1,348		7.9	%	667		6.2	%	1,057		6.5	%
Real estate – multi-family and farmland	1,068		3.5	%	741		3.1	%	1,640		4.2	%
Commercial loans	1,020		9.5	%	2,103		11.3	%	2,827		10.1	%
Consumer installment loans	133		4.0	%	272		2.5	%	397		2.6	%
Leases, net of unearned income	8		0.1	%	47		0.1	%	87		0.1	%
Other	14		0.8	%	27		1.0	%	25		0.8	%
Total	$	10,700	100.0	%	$	13,800	100.0	%	$	17,490	100.0	%

__________________

¹ Represents the percentage of loans in each category to total loans.

Throughout the economic downturn, the ratio of the allowance to total loans was significantly increased largely because of the level of nonperforming loans and the associated decline in real estate values. These two factors contributed to elevated levels of classified loans, which is a driving component of the allowance. Since September 30, 2012, we have experienced a significant decline in the level of non-performing loans. Nonperforming loans were $7.3 million, $26.7 million and $34.8 million at September 30, 2013, December 31, 2012, and September 30, 2012, respectively. When comparing September 2013 to December 2012 non-performing loans decreased $19.5 million, and when compared to September 30, 2012, non-performing loans have decreased $27.6 million. During the fourth quarter of 2012, we identified approximately $36.2 million of under- and non-performing loans and recorded a $13.9 million charge-off to reduce the balance to the estimated net proceeds. These loans were sold in the first quarter of 2013. The majority of the reductions in non-performing loans is directly associated with the loan sale. Our ratio of non-performing loans to total loans was 1.37% as of September 30, 2013 as compared to 4.94% as of December 31, 2012 and 6.07% as of September 30, 2012. Additionally, our net charge-offs during 2013 have further supported our improving asset quality. Specifically, net charges-offs for the third quarter of 2013 were a recovery of $32 thousand and year-to-date charge-offs total only $1.3 million, or 0.32% of average loans on an annualized basis.

The combination of positive asset quality trends as well as low loss rates for the prior three quarters resulted in a reduction in our allowance to loans ratio to 2.00%. With minimal net charge-offs, the reduction of the allowance resulted in negative provision expense for the quarter and year-to-date periods. We anticipate that our allowance model may support a lower allowance to loans ratio with continuation of the current asset quality and charge-off trends.

We utilize a risk rating system to evaluate the credit risk of our loan portfolio. We classify loans as: pass, special mention, substandard, doubtful or loss. We assign a pass rating to loans that are performing as contractually agreed and do not exhibit the characteristics of heightened credit risk. A special mention risk rating is assigned to loans that are criticized but not considered to have weaknesses as serious as those of a classified loan. Special mention loans generally contain one or more potential weaknesses, which if not corrected, could result in an unacceptable increase in the credit risk at some future date. A substandard risk rating is assigned to loans that have specifically identified weaknesses and deficiencies typically resulting from severe adverse trends of a financial, economic or managerial nature and may require nonaccrual status. Substandard loans have a greater likelihood of loss. We assign a doubtful risk rating to loans that the collection or liquidation in full of principal and/or interest is highly questionable or improbable. Any loans that are assigned a risk rating of loss are fully charged-off in the period of the downgrade.

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We segregate substandard loans into two classifications based on our allowance methodology for impaired loans. An impaired loan is defined as a substandard loan relationship in excess of $500 thousand that is also on nonaccrual status. These relationships are individually reviewed on a quarterly basis to determine the required allowance or loss, as applicable.

For the allowance analysis, the primary categories are: pass, special mention, substandard – non-impaired, and substandard – impaired. Loans in the substandard and doubtful loan categories are combined and impaired loans are segregated from non-impaired loans.

The following tables present our internal risk rating by loan classification as utilized in the allowance analysis as of September 30, 2013, December 31, 2012 and September 30, 2012:

As of September 30, 2013



	Pass		Special Mention		Substandard – Non-impaired		Substandard – Impaired		Total
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	152,115	$	9,182	$	10,725	$	1,424	$	173,446
Real estate: Commercial	207,015		5,206		10,024		358		222,603
Real estate: Construction	37,723		83		4,532		26		42,364
Real estate: Multi-family and farmland	16,947		999		898		—		18,844
Commercial	44,572		2,868		2,683		756		50,879
Consumer	21,228		79		279		—		21,586
Leases	—		—		42		—		42
Other	4,810		—		53		—		4,863
Total Loans	$	484,410	$	18,417	$	29,236	$	2,564	$	534,627

As of December 31, 2012



	Pass		Special Mention		Substandard – Non-impaired		Substandard – Impaired		Total
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	164,555	$	7,668	$	15,511	$	457	$	188,191
Real estate: Commercial	207,188		4,930		8,810		727		221,655
Real estate: Construction	30,471		97		1,056		1,783		33,407
Real estate: Multi-family and farmland	14,025		1,794		1,232		—		17,051
Commercial	51,972		756		6,593		2,077		61,398
Consumer	12,793		126		468		—		13,387
Leases	1		74		101		392		568
Other	5,365		—		108		—		5,473
Total Loans	$	486,370	$	15,445	$	33,879	$	5,436	$	541,130

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As of September 30, 2012



	Pass		Special Mention		Substandard – Non-impaired		Substandard – Impaired		Total
	(in thousands)
Loans by Classification
Real estate: Residential 1-4 family	$	169,964	$	7,355	$	19,033	$	4,214	$	200,566
Real estate: Commercial	205,863		3,319		14,105		9,183		232,470
Real estate: Construction	30,750		108		2,795		4,091		37,744
Real estate: Multi-family and farmland	14,233		2,180		6,857		805		24,075
Commercial	43,690		857		12,201		1,297		58,045
Consumer	14,136		80		541		—		14,757
Leases	—		196		153		422		771
Other	4,828		—		109		—		4,937
Total Loans	$	483,464	$	14,095	$	55,794	$	20,012	$	573,365

We classify a loan as impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. Impaired loans were $2.6 million at September 30, 2013, $5.4 million at December 31, 2012 and $20.0 million at September 30, 2012. For impaired loans, any payments made by the borrower are generally applied directly to principal.

The allowance associated with specific impaired loans totaled zero as of September 30, 2013, compared to $50 thousand as of December 31, 2012. General reserves totaled $10.7 million as of September 30, 2013, compared to $13.8 million as of December 31, 2012. Specific reserves are based on our evaluation of each impaired relationship. The general reserve is determined by applying the historical loss factor and qualitative and environmental factors to the applicable loan pools. Our allowance as a percentage of total loans has decreased mostly due to a decrease in the loan portfolio and a decrease in non-performing loans. The ratio of the general reserves to the applicable loan pools has declined from 2.57% as of December 31, 2012 to 2.0% as of September 30, 2013.

We believe that the allowance for loan and lease losses as of September 30, 2013 is sufficient to absorb probable incurred losses in the loan portfolio based on our assessment of the information available, including the results of ongoing internal reviews of our loan portfolio, as discussed in the Asset Quality and Non-Performing Assets section below. Our assessment involves uncertainty and judgment; therefore, the adequacy of the allowance cannot be determined with precision and may be subject to change in future periods. In addition, bank regulatory authorities, as part of their periodic examinations, may require additional charges to the provision for loan losses in future periods if the results of their reviews warrant.

Asset Quality and Non-Performing Assets

Asset Quality Strategic Initiatives

Our ability to return to profitability is largely dependent on properly addressing and improving asset quality. As of September 30, 2013, our loan portfolio was 52.8% of total assets. Over the past three and a half years, we have implemented a number of significant strategies to further address our asset quality, with the under- and non-performing loans sale accounting for a significant component of those strategies. As of September 30, 2013, our asset quality is consistent with or better than our peer group. We believe our continued implementation of these and related strategies will enable us to show further improvement in our asset quality in 2013.

During the fourth quarter of 2009, we began the process of restructuring our credit administration department to add additional depth and expertise and to fully centralize our credit underwriting process. With the additional depth and expertise of the restructured credit department, in 2010 we centralized our loan underwriting, document preparation and collections processes. This centralization has improved consistency, increased quality and provided higher levels of operational efficiencies. Collectively, we believe these changes will assist in reducing current and future non-performing assets.

Our internal loan review department performs risk-based reviews and historically targets 60% to 70% of our portfolio over an 18-month cycle. To achieve such coverage, we have continued to use third parties to supplement the coverage of our internal loan review department. During 2012, we achieved the 60% to 70% review of our portfolio over a 12-month cycle, focusing on a risk-based approach. We anticipate similar coverage during 2013.

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During the second half of 2010, we began outsourcing the marketing and sales process of our OREO properties to market leading real estate companies. We experienced higher volumes of OREO sales in 2011 and 2012, and this trend has continued through the first nine months of 2013. We expect to continue seeing high levels of sales during the fourth quarter of 2013 and continue into 2014.

On February 9, 2012, we hired Christopher G. Tietz as Executive Vice President and Chief Credit Officer. Mr. Tietz has over 25 years of banking knowledge with extensive experience in credit administration. Mr. Tietz joined First Security from First Place Bank in Warren, Ohio, a $3 billion bank, where he served as EVP and Chief Credit Officer since May 2011. From 2005 to April 2011, Mr. Tietz worked for Monroe Bank in Bloomington, Indiana as Chief Credit Officer. Mr. Tietz began his career in Nashville, Tennessee with First American National Bank where he spent fifteen years, with the final five years serving as EVP and Regional Senior Credit Officer.

Asset Quality and Non-Performing Assets Analysis and Discussion

Following the under- and non-performing loan sale, our asset quality ratios are consistent with or better than our peer group. Our peer group, as defined by the Uniform Bank Performance Report (UBPR), is all commercial banks between $1 billion and $3 billion in total assets. During the remainder of 2013, we will continue to focus on reducing our OREO portfolio and improving overall asset quality.

As of September 30, 2013, our allowance for loan and lease losses as a percentage of total loans was 2.00%, which is a decrease from the 2.55% as of December 31, 2012 and a decrease from the 3.05% as of September 30, 2012. Net charge-offs as a percentage of average loans (annualized) decreased to 0.32% for the nine months ended September 30, 2013 compared to 2.83% for the same period in 2012. As of September 30, 2013, non-performing assets decreased to $16.0 million, or 1.58% of total assets, from $40.2 million, or 3.78% of total assets as of December 31, 2012 and decreased from $50.7 million, or 4.54% of total assets as of September 30, 2012. The allowance as a percentage of total non-performing loans was 126.1% as of September 30, 2013 compared to 51.6% at December 31, 2012 and 50.2% at September 30, 2012.

We believe that overall asset quality will continue to improve in the following quarters although not at the same rate as seen over the last 12 months in connection with the Recapitalization and loan sale. From December 31, 2012 to September 30, 2013, we have seen positive results in improving our asset quality. Special mention loans increased $3.0 million, or 19.2%, from $15.4 million as of December 31, 2012 to $18.4 million as of September 30, 2013. Comparing September 30, 2013 to September 30, 2012, special mention loans increased by $4.3 million, or 30.7%. Substandard loans decreased $7.5 million, or 19.1%, from $39.3 million at December 31, 2012 to $31.8 million at September 30, 2013. Comparing September 30, 2013 to September 30, 2012, substandard loans decreased by $44.0 million, or 58.1%. Even though our special mention loans are up slightly from previous periods, we believe based on the trends in substandard loans, there is minimal additional migration to nonperforming loans from the performing loans. We have also achieved steady reductions in other real estate owned. OREO declined by $4.8 million, or 35.6%, from $13.4 million as of December 31, 2012 to $8.7 million as of September 30, 2013. Comparing September 30, 2013 to September 30, 2012, OREO declined by $7.1 million, or 45.2%. This is a direct result of our increased efforts to liquidate and sell our OREO properties.

Nonperforming assets include nonaccrual loans, loans past-due over ninety days and still accruing, restructured loans, OREO and repossessed assets. We place loans on non-accrual status when we have concerns relating to our ability to collect the loan principal and interest, and generally when such loans are 90 days or more past due. Non-performing loans decreased, in part, due to the loan sale that closed in February 2013. See Note 7 to our consolidated financial statements for additional information on the loan sale. The following table, which includes both loans held-for-sale and loans held-for-investment, presents our non-performing assets and related ratios.

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NON-PERFORMING ASSETS BY TYPE



	September 30, 2013			December 31, 2012			September 30, 2012
	(in thousands, except percentages)
Nonaccrual loans	$	6,803		$	25,071		$	32,254
Loans past due 90 days and still accruing	509			1,656			2,572
Total nonperforming loans, including loans 90 days and still accruing	$	7,312		$	26,727		$	34,826

Other real estate owned	$	8,662		$	13,441		$	15,803
Repossessed assets	16			8			51
Total nonperforming assets	$	15,990		$	40,176		$	50,680

Nonperforming loans as a percentage of total loans	1.37		%	4.94		%	6.07		%
Nonperforming assets as a percentage of total assets	1.58		%	3.78		%	4.54		%

The following table provides the classifications for nonaccrual loans and other real estate owned as of September 30, 2013, December 31, 2012 and September 30, 2012.

NON-PERFORMING ASSETS – CLASSIFICATION AND NUMBER OF UNITS



	September 30, 2013			December 31, 2012			September 30, 2012
	Amount		Units	Amount		Units	Amount		Units
	(dollar amounts in thousands)
Nonaccrual loans
Construction/development loans	$	461	5	$	4,516	41	$	5,579	26
Residential real estate loans	3,464		51	9,217		217	10,269		123
Commercial real estate loans	996		8	6,150		69	12,827		37
Commercial and industrial loans	1,605		29	3,104		56	2,654		33
Commercial leases	20		3	436		42	496		42
Consumer and other loans	257		8	1,648		34	429		14
Total	$	6,803	104	$	25,071	459	$	32,254	275
Other real estate owned
Construction/development loans	$	3,860	241	$	6,163	351	$	7,154	86
Residential real estate loans	1,555		42	1,921		86	2,696		51
Commercial real estate loans	2,519		29	4,211		39	972		2
Multi-family and farmland	381		2	873		3	4,981		25
Commercial and industrial loans	347		2	273		2	—		—
Total	$	8,662	316	$	13,441	481	$	15,803	164

Nonaccrual loans totaled $6.8 million, $25.1 million and $32.3 million as of September 30, 2013, December 31, 2012 and September 30, 2012, respectively. As of September 30, 2013 and 2012, non-accrual loans and loans past due ninety days and still accruing did not include any loans held-for-sale. Of the non-accrual loans as of December 31, 2012, $11.7 million relate to loans held-for-investment and $13.4 million relate to loans transferred to loans held-for-sale. Loans past due ninety days and still accruing include $938 thousand from loans held-for-investment and $718 thousand of loans transferred to loans held-for-sale at December 31, 2012. We place loans on nonaccrual when we have concerns related to our ability to collect the loan principal and interest, and generally when loans are 90 or more days past due. As of September 30, 2013, we are not aware of any additional material loans that we have doubts as to the collectability of principal and interest that are not classified as nonaccrual. As previously described, we have individually reviewed each nonaccrual loan in excess of $500 thousand for possible impairment. We measure impairment by adjusting loans to either the present value of expected cash flows, the fair value of the collateral or observable market prices.

As of September 30, 2013, nonaccrual loans decreased by $18.3 million, or 72.9%, compared to year-end 2012. Comparing September 30, 2013 to December 31, 2012, nonaccrual construction and development loans decreased by $4.1 million, residential real estate loans decreased by $5.8 million and commercial real estate loans decreased by $5.2 million. The

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decreases were primarily due to the loan sale that closed in February of 2013 as well as charge-offs and principal payments. See Note 7 of our consolidated financial statements for additional discussion regarding the loan sale. We continue to actively pursue appropriate strategies to reduce the current level of nonaccrual loans.

OREO decreased $4.8 million from December 31, 2012 to September 30, 2013. As previously mentioned, we have outsourced the marketing and sales process of our OREO properties to market-leading real estate firms. During 2012, we sold 205 properties for $15.0 million. During the nine months ended September 30, 2013, we sold 62 properties for $6.4 million. During April 2012, we conducted a bulk auction on approximately 90 properties consisting of smaller balance 1-4 family residential and lot properties. This auction resulted in an approximate 50% decline in the number of properties, thus allowing our special assets department to focus on the larger value properties remaining in our portfolio. We expect continued OREO resolutions during 2013 due to our new approach to marketing these properties and general stabilization in the real estate markets in our footprint.

Loans 90 days past due and still accruing increased $81 thousand for the quarter. As of September 30, 2013, the $509 thousand in loans 90 days past due and still accruing was composed of $496 thousand in residential real estate loans and $13 thousand of multi-family real estate.

Loans 90 days past due and still accruing were $1.7 million as of December 31, 2012. Of these past due loans as of December 31, 2012, residential real estate loans totaled$1.0 million, $484 thousand in commercial and industrial loans and the remainder in other categories.

For the quarter ending September 30, 2012, loans 90 days past due and still accruing decreased $64 thousand. As of September 30, 2012, the $2.6 million in loans 90 days past due and still accruing was composed of $1.6 million in residential real estate loans, $577 thousand in commercial real estate loans, $34 thousand in commercial loans, and the remainder in other categories.

Total non-performing assets as of the third quarter of 2013 were $16.0 million compared to $40.2 million at December 31, 2012 and $50.7 million at September 30, 2012.

As of September 30, 2013, our asset quality ratios are consistent with or more favorable than our peer group. As previously stated, we monitor our asset quality against our peer group, as defined by all commercial banks with $1 billion to $3 billion in total assets as presented in the UBPR. The following table provides our asset quality ratios and our UBPR peer group ratios as of September 30, 2013, which is the latest available information.

NONPERFORMING ASSET RATIOS



	First Security Group, Inc.		UBPR Peer Group
Nonperforming loans¹ as a percentage of gross loans	1.37	%	1.60	%
Nonperforming loans¹ as a percentage of the allowance	68.34	%	99.64	%
Nonperforming loans¹ as a percentage of equity capital	8.77	%	9.69	%
Nonperforming loans¹ plus OREO as a percentage of gross loans plus OREO	2.94	%	2.42	%

__________________

¹ Nonperforming loans are nonaccrual loans plus loans 90 days past due and still accruing

Investment Securities and Other Earning Assets

The composition of our securities portfolio reflects our investment strategy of maintaining an appropriate level of liquidity while providing a relatively stable source of income. Our securities portfolio also provides a balance to interest rate risk and credit risk in other categories of the balance sheet while providing a vehicle for investing available funds, furnishing liquidity and supplying securities to pledge as required collateral for certain deposits and borrowed funds. Currently, our investments are classified as either available-for-sale or held-to-maturity. As of September 30, 2013, we have no plans to liquidate a significant amount of available-for-sale securities. However, the securities classified as available-for-sale may be used for liquidity purposes should we deem it to be in our best interest.

Available-for-sale securities totaled $207.0 million at September 30, 2013, $254.1 million at December 31, 2012 and $257.3 million at September 30, 2012. Held-to-maturity securities totaled $129.4 million at September 30, 2013. The held-to-maturity securities were transferred from the available-for-sale securities in the third quarter of 2013. We maintain a level of securities to provide an appropriate level of liquidity and to provide a proper balance to our interest rate and credit risk in our loan portfolio. The increase in the first two quarters represented a decision in connection with the Recapitalization that liquidity was sufficient to warrant the shifting of additional cash into investment securities, and further purchases throughout 2013 may

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be warranted. At September 30, 2013 and 2012, the available-for-sale securities portfolio had gross unrealized gains of approximately $2.6 million and $5.5 million, and gross unrealized losses of $3.0 million and $294 thousand, respectively. At September 30, 2013, the held-to maturity securities had gross unrecognized gains of $1.4 million and gross unrecognized losses of $390 thousand. Our securities portfolio at September 30, 2013 consisted of tax-exempt municipal securities, federal agency bonds, federal agency issued Real Estate Mortgage Investment Conduits (REMICs), federal agency issued pools, collateralized loan obligations and corporate bonds.

The following table provides the amortized cost of our available-for-sale securities by their stated maturities (this maturity schedule excludes security prepayment and call features), as well as the tax equivalent yields for each maturity range.

MATURITY OF AFS INVESTMENT SECURITIES – AMORTIZED COST



	Less than One Year			One to Five Years			Five to Ten Years			More Than Ten Years			Totals
	(in thousands, except percentages)
Municipal - tax exempt	$	1,591		$	10,883		$	6,591		$	12,653		$	31,718
Municipal - taxable	—			842			—			776			1,618
Agency bonds	—			—			2,009			4,168			6,177
Agency issued REMICs	595			46,155			8,940			—			55,690
Agency issued mortgage pools	—			56,141			28,992			5,698			90,831
Other	—			—			18,867			2,476			21,343
Total	$	2,186		$	114,021		$	65,399		$	25,771		$	207,377
Tax Equivalent Yield	5.54		%	2.46		%	2.01		%	2.29		%	2.43		%

We currently have the ability and intent to hold our available-for-sale investment securities to maturity. However, should conditions change, we may sell unpledged securities. We consider the overall quality of the securities portfolio to be high. All securities held are historically traded in liquid markets, except for one bond, which is valued utilizing Level 3 inputs. The Level 3 security was a pooled trust preferred security with a book value of $61 thousand.

As of September 30, 2013, we performed an impairment assessment of the securities in our portfolio that had an unrealized loss to determine whether the decline in the fair value of these securities below their cost was other-than-temporary. Under authoritative accounting guidance, impairment is considered other-than-temporary if any of the following conditions exists: (1) we intend to sell the security, (2) it is more likely than not that we will be required to sell the security before recovery of its amortized cost basis or (3) we do not expect to recover the security’s entire amortized cost basis, even if we do not intend to sell. Additionally, accounting guidance requires that for impaired securities that we do not intend to sell and/or that it is not more-likely-than-not that we will have to sell prior to recovery but for which credit losses exist, the other-than-temporary impairment should be separated between the total impairment related to credit losses, which should be recognized in current earnings, and the amount of impairment related to all other factors, which should be recognized in other comprehensive income. If a decline is determined to be other-than-temporary due to credit losses, the cost basis of the individual security is written down to fair value, which then becomes the new cost basis. The new cost basis would not be adjusted in future periods for subsequent recoveries in fair value, if any.

In evaluating the recovery of the entire amortized cost basis, we consider factors such as (1) the length of time and the extent to which the market value has been less than cost, (2) the financial condition and near-term prospects of the issuer, including events specific to the issuer or industry, (3) defaults or deferrals of scheduled interest, principal or dividend payments and (4) external credit ratings and recent downgrades.

As of September 30, 2013, gross unrealized losses in our portfolio totaled $3.0 million, compared to $384 thousand and $294 thousand as of December 31, 2012 and September 30, 2012, respectively. The unrealized losses in mortgage-based residential, municipal, and federal agency securities are primarily a result of widening credit spreads subsequent to purchase. The unrealized loss in other securities relate to four corporate notes and one pooled trust preferred security. The unrealized loss in the corporate notes is primarily due to changes in interest rates subsequent to purchase. The unrealized losses associated with the trust preferred security are primarily due to widening credit spreads subsequent to purchase and a lack of demand for trust preferred securities. Based on results of our impairment assessment, the unrealized losses at September 30, 2013 are considered temporary.

As of September 30, 2013, we owned securities from issuers in which the aggregate amortized cost from such issuers exceeded 5% of our shareholders’ equity. The following table presents the amortized cost and market value of the securities from each such issuer as of September 30, 2013.

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	Amortized Cost		Market Value
	(in thousands)
Federal National Mortgage Association (FNMA)	$	97,087	$	96,246
Federal Home Loan Mortgage Corporation (FHLMC)	$	44,224	$	44,040
Government National Mortgage Association (GNMA)	$	47,307	$	46,743

We held no federal funds sold as of September 30, 2013, December 31, 2012 or September 30, 2012. As of September 30, 2013, we held $59.9 million in interest bearing deposits, primarily at the Federal Reserve Bank of Atlanta, compared to $159.7 million at December 31, 2012 and $201.6 million as of September 30, 2012. The yield on our account at the Federal Reserve Bank is approximately 25 basis points.

As of September 30, 2013, we held approximately $2.9 million in certificates of deposit at FDIC insured financial institutions. At September 30, 2013, we held $28.2 million in bank-owned life insurance, compared to $27.6 million at December 31, 2012 and $27.4 million at September 30, 2012.

Deposits and Other Borrowings

As of September 30, 2013, total deposits decreased by 9.7% (13.0% annualized) from December 31, 2012 and decreased by 12.9% from September 30, 2012, principally because of planned reductions in brokered deposits. Excluding brokered deposits, our deposits decreased by 2.6% (3.5% annualized) from December 31, 2012 and decreased 3.5% from September 30, 2012. In the first nine months of 2013, the fastest growing sectors of our core deposit base were savings and money market accounts, which grew 16.6% (22.0% annualized). We define our core deposits to include interest bearing and noninterest bearing demand deposits, savings and money market accounts, as well as retail certificates of deposit with denominations less than $100,000. Core deposits increased by $9.7 million, or 1.5% (2.0% annualized), from December 31, 2012. We consider our retail certificates of deposit to be a stable source of funding because they are in-market, relationship-oriented deposits. Core deposit growth is an important tenet of our business strategy.

Brokered certificates of deposits decreased $104.3 million from September 30, 2012 to September 30, 2013 due to scheduled and called maturities. In addition to brokered certificates of deposits, we are a member bank of the Certificate of Deposit Account Registry Service (CDARS) network. CDARS is a network of banks that allows customers’ CDs to receive full FDIC insurance of up to $50 million. Additionally, members have the opportunity to purchase or sell one-way time deposits. As of September 30, 2013, our CDARS balance consists of $373 thousand in purchased time deposits and no reciprocal customer accounts.

Brokered deposits at September 30, 2013, December 31, 2012 and September 30, 2012 were as follows:

BROKERED DEPOSITS



	September 30, 2013		December 31, 2012		September 30, 2012
	(in thousands)
Brokered certificates of deposits	$	88,614	$	165,106	$	191,834
CDARS®	373		371		1,414
Total	$	88,987	$	165,477	$	193,248

As discussed in Note 2 of our consolidated financial statements, the presence of a capital requirement in the Order restricts our ability to accept, renew, or roll over brokered deposits without prior approval of the FDIC. The liquidity enhancement over the last two years was in part to ensure we have adequate funding to meet our short-term contractual obligations. We believe that our current liquidity, along with maintaining or increasing core deposits, will provide for our short-term contractual obligations, including maturing brokered deposits. The table below is a maturity schedule for our brokered CDs as of September 30, 2013.

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BROKERED DEPOSITS – BY MATURITY



	Less than three months		Three months to six months		Six months to twelve months		One to two years		Greater than two years
	(in thousands)
Brokered certificates of deposit	$	13,926	$	10,403	$	29,846	$	27,672	$	6,767
CDARS®	—		—		—		373		—
Total	$	13,926	$	10,403	$	29,846	$	28,045	$	6,767

As of September 30, 2013, December 31, 2012 and September 30, 2012, we had no Federal funds purchased.

Securities sold under agreements to repurchase with commercial checking customers were $12.7 million as of September 30, 2013, compared to $12.5 million and $14.7 million as of December 31, 2012 and September 30, 2012, respectively. As of September 30, 2012, we also had a structured repurchase agreement with another financial institution of $10.0 million. The agreement had a five year term with a variable rate of three-month LIBOR minus 75 basis points for the first year and a fixed rate of 3.93% for the remaining term. The agreement matured in November 2012.

Liquidity

Liquidity refers to our ability to adjust future cash flows to meet the needs of our daily operations. We rely primarily on management fees from FSGBank to fund our daily operations’ liquidity needs. Our cash balance on deposit with FSGBank, which totaled approximately $1.6 million as of September 30, 2013, is available for funding activities for which FSGBank would not receive direct benefit, such as shareholder relations and holding company operations. These funds should adequately meet our cash flow needs. As discussed in Note 2 to our consolidated financial statements, the Agreement with the Federal Reserve requires prior written authorization for any payment to First Security that reduces the equity of FSGBank, including management fees. If we determine that our cash flow needs will be satisfactorily met, we may deploy a portion of the funds into FSGBank.

The liquidity of FSGBank refers to the ability or financial flexibility to adjust its future cash flows to meet the needs of depositors and borrowers and to fund operations on a timely and cost effective basis. The primary sources of funds for FSGBank are cash generated by repayments of outstanding loans, interest payments on loans and new deposits. Additional liquidity is available from the maturity and earnings on securities and liquid assets, as well as the ability to liquidate available-for-sale securities.

As of September 30, 2013, our interest bearing account at the Federal Reserve Bank of Atlanta totaled approximately $56.9 million. This liquidity is available to fund our contractual obligations and prudent investment opportunities.

Our borrowing capacity (using 1-4 family residential mortgages) for FSGBank at the FHLB required the individual pledging and physical delivery of loan files. As of September 30, 2013, no individual loans were provided to the FHLB.

Another source of funding is loan participations sold to other commercial banks (in which we retain the servicing rights). As of quarter-end, we had approximately $1.8 million in loan participations sold. FSGBank may sell loan participations as a source of liquidity. An additional source of short-term funding would be to pledge investment securities against a line of credit at a commercial bank. As of quarter-end, FSGBank had $90.3 million in investment securities pledged for repurchase agreements, treasury tax and loan deposits, and public-fund deposits attained in the ordinary course of business. As of September 30, 2013, our unpledged investment securities totaled $116.7 million.

Historically, we have utilized brokered deposits to provide an additional source of funding. As of September 30, 2013, we had $88.6 million in brokered CDs outstanding with a weighted average remaining life of approximately 12 months, a weighted average coupon rate of 2.95% and a weighted average all-in cost (which includes fees paid to deposit brokers) of 2.99%. Our CDARS product had $373 thousand at September 30, 2013, with a weighted average coupon rate of 2.70% and a weighted average remaining life of approximately 13 months. Our certificates of deposit greater than $100 thousand were generated in our communities and are considered relatively stable. We are also approved to use the Federal Reserve discount window. We applied to utilize the Federal Reserve window as an abundance of caution due to the economic climate. As discussed in Note 2 of our consolidated financial statements, the presence of a capital requirement in our Order restricts our ability to accept, renew or roll over brokered deposits without prior approval of the FDIC.

Management believes that our liquidity sources are adequate to meet our current operating needs. We continue to study our contingency funding plans and update them as needed paying particular attention to the sensitivity of our liquidity and deposit base to positive and negative changes in our asset quality.

We also have contractual cash obligations and commitments, which include certificates of deposit, other borrowings, operating leases and loan commitments. Unfunded loan commitments and standby letters of credit totaled $122.9 million at

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September 30, 2013. The following table illustrates our significant contractual obligations at September 30, 2013 by future payment period.

CONTRACTUAL OBLIGATIONS



			Less than One Year		One to Three Years		Three to Five Years		More than Five Years		Total
			(in thousands)
Certificates of deposit	(1	)	$	319,299	$	41,476	$	4,820	$	—	$	365,595
Brokered certificates of deposit	(1	)	54,175		32,463		1,976		—		88,614
CDARS®	(1	)	—		373		—		—		373
Federal funds purchased and securities sold under agreements to repurchase	(2	)	12,657		—		—		—		12,657
Operating lease obligations	(3	)	719		1,991		1,363		2,454		6,527
Total			$	386,850	$	76,303	$	8,159	$	2,454	$	473,766

__________________


1.	Certificates of deposits give customers rights to early withdrawal which may be subject to penalties. The penalty amount depends on the remaining time to maturity at the time of early withdrawal. For more information regarding certificates of deposit, see “Deposits and Other Borrowings.”


2.	We expect securities repurchase agreements to be re-issued and, as such, do not necessarily represent an immediate need for cash.


3.	Operating lease obligations include existing and future property and equipment non-cancelable lease commitments.

Net cash used by operations during the first nine months of 2013 totaled $10.9 million compared to net cash used in operations of $4.2 million for the same period in 2012. Net cash used in investing activities totaled $68.4 million for the nine months ended September 30, 2013, compared to net cash used in investing activities of $66.9 million for the same period in 2012. The decrease in cash used is associated with an increase in the purchase of investment securities of $59.3 million, partially offset by an increase in sales of investment securities and the sale of loans held-for-sale to a third party of $22.3 million. Net cash used in financing activities was $22.9 million for the first nine months of 2013 compared to net cash provided by financing activities of $24.8 million in the comparable 2012 period. The decrease in cash used in financing activities is primarily related to proceeds from issuance of common stock of $81.2 million, offset by a decrease in deposits of $98.2 million.

Derivative Financial Instruments

Derivatives are used as a risk management tool and to facilitate client transactions. We utilize derivatives to hedge the exposure to changes in interest rates or other identified market risks. Derivatives may also be used in a dealer capacity to facilitate client transactions by creating customized loan products for our larger customers. These products allow us to meet the needs of our customers, while minimizing our interest rate risk. We currently have not entered into any transactions in a dealer capacity.

The Asset/Liability Committee of the Board of Directors (ALCO) provides oversight by ensuring that policies and procedures are in place to monitor our significant derivative positions. We believe the use of derivatives will reduce our interest rate risk and potential earnings volatility caused by changes in interest rates.

Our derivatives are based on underlying risks, primarily interest rates. Historically, we have utilized cash flow swaps to reduce the risks associated with interest rates. On August 28, 2007 and March 26, 2009, we elected to terminate a series of interest rate swaps with a total notional value of $150 million and $50 million, respectively. At termination, the swaps had a market value of $2.0 million and $5.8 million, respectively. These gains were accreted into interest income over the remaining life of the originally hedged items. The gains were fully accreted into income at December 31, 2012. We recognized $1.2 million in interest income for the nine months ended September 30, 2012.

We also use forward contracts to hedge against changes in interest rates on our held for sale loan portfolio. Our practice is to enter into a best efforts contract with the investor concurrently with providing an interest rate lock to a customer. The use of the fair value option on the closed held for sale loans and the forward contracts minimize the volatility in earnings from changes in interest rates.

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The following table presents information on the cash flow and fair value hedges as of September 30, 2013.



	Notional Amount		Gross Unrealized Gains		Gross Unrealized Losses			Accumulated Other Comprehensive Income			Maturity Date
	(in thousands)
Asset hedges
Cash flow hedges:
Forward loan sales contracts	$	1,661	$	—	$	49		$	(77	)	Various
Fair value hedges:
Zero premium collar	1,542		33		—			—			June 10, 2023
Cash flow swap	1,542		—		(33		)	—			June 10, 2023
	$	4,745	$	33	$	16		$	(77	)

The following table presents additional information on the active derivative positions as of September 30, 2013.

Consolidated Balance

Sheet Presentation

Consolidated Income

Statement Presentation

Assets

Liabilities

Gains

Notional

Classification

Amount

Classification

Amount

Classification

Amount

Recognized

(in thousands)

Hedging Instrument:

Forward contracts

1,661

Other assets

—

Other liabilities

Noninterest

income – other

Zero premium collar

1,542

Other assets

Other liabilities

N/A

Noninterest income – other

Cash flow swap

1,542

Other assets

N/A

Other liabilities

Noninterest expense – other

Hedged Items:

Loans held for sale

N/A

Loans held for

sale

1,661

N/A

Noninterest

income – other

N/A

Loans

N/A

Loans

1,542

N/A

Noninterest income - other

N/A

Derivatives expose us to credit risk from the counterparty when the derivatives are in an unrealized gain position. All counterparties must be approved by the Board of Directors and are monitored by ALCO on an ongoing basis. We minimize the credit risk exposure by requiring collateral when certain conditions are met. When the derivatives are at an unrealized loss position, our counterparty may require us to pledge collateral.

Off-Balance Sheet Arrangements

We are party to credit-related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of our customers. These financial instruments include commitments to extend credit. Such commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated balance sheets.

Our exposure to credit loss is represented by the contractual amount of these commitments. We follow the same credit policies in making commitments as we do for on-balance sheet instruments.

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The following table discloses our maximum exposure to credit risk for unfunded loan commitments and standby letters of credit at the dates indicated.



	As of
	September 30, 2013		December 31, 2012		September 30, 2012
	(in thousands)
Commitments to extend credit - fixed rate	$	29,464	$	16,312	$	20,430
Commitments to extend credit - variable rate	90,086		94,822		81,722
Total Commitments to extend credit	$	119,550	$	111,134	$	102,152

Standby letters of credit	$	3,308	$	5,023	$	4,867

Commitments to extend credit are agreements to lend to customers. Commitments generally have fixed expiration dates or other termination clauses and may require payment of fees. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements. We evaluate each customer’s creditworthiness on a case-by-case basis. The amount of collateral, if any, we obtain on an extension of credit is based on our credit evaluation of the customer. Collateral held varies but may include accounts receivable, inventory, property and equipment and income-producing commercial properties.

Capital Resources

Banks and bank holding companies, as regulated institutions, must meet required levels of capital. The OCC and the Federal Reserve, the primary federal regulators for FSGBank and First Security, respectively, have adopted minimum capital regulations or guidelines that categorize components and the level of risk associated with various types of assets. Financial institutions are expected to maintain a level of capital commensurate with the risk profile assigned to their assets in accordance with the guidelines. As described in Note 2 to our consolidated financial statements, the Order requires FSGBank to achieve and maintain total capital to risk adjusted assets of at least 13% and a leverage ratio of at least 9%. The Order provided 120 days from April 28, 2010, the effective date of the Order, to achieve these ratios. As shown below, FSGBank is not currently in compliance with the capital requirements. Pursuant to the Agreement, the Company is prohibited from declaring or paying dividends without the prior written consent of the Federal Reserve. Any future determination relating to dividend policy will be made at the discretion of our Board of Directors and will depend on a number of factors, including our future earnings, capital requirements, financial condition, future prospects, regulatory restrictions, and other factors that our Board of Directors may deem relevant. Our ability to distribute cash dividends in the future may be limited by regulatory restrictions and the need to maintain sufficient consolidated capital.

On April 11, 2013, we completed a restructuring of the Company's Preferred Stock with the Treasury by issuing $14.9 million of new common stock for $1.50 per share for the full satisfaction of the Treasury's 2009 investment in the Company. Pursuant to the Exchange Agreement, as previously included in a Current Report on Form 8-K filed on February 26, 2013, we restructured the Company's Preferred Stock issued under the Capital Purchase Program by issuing new shares of common stock equal to 26.75% of the $33 million value of the Preferred Stock plus 100% of the accrued but unpaid dividends in exchange for the Preferred Stock, all accrued but unpaid dividends thereon, and the cancellation of stock warrants granted in connection with the CPP investment. Immediately after the issuance of the common stock to the Treasury, the Treasury sold all of the Company's common stock to investors previously identified by the Company at the same $1.50 per share price.

On April 12, 2013, we completed the issuance of an additional $76.2 million of new common stock in a private placement to accredited investors. The private placement was previously announced on a Current Report on Form 8-K filed on February 26, 2013, in which we announced the execution of definitive stock purchase agreements with institutional investors as part of an approximately $90 million Recapitalization. In total, we issued 60,735,000 shares of common stock at $1.50 per share for gross proceeds of $91.1 million. See Note 2 to our Consolidated Financial Statements for additional information.

On September 27, 2013, we completed the issuance of an additional $5.0 million of new common stock through the Rights Offering. The Rights Offering was previously announced on a Current Report on Form 8-K filed on February 26, 2013. Under the Rights Offering each Legacy Shareholder received one non-transferable subscription right to purchase two shares of our common stock at the subscription price of $1.50 per share for every one share of common stock owned by such Legacy Shareholder as of the record date of April 10, 2013. Additionally, each Legacy Shareholder that fully exercised such Legacy Shareholder's subscription rights had the ability to submit an over-subscription request to purchase additional shares of common stock, subject to certain limitations and subject to allotment under the Rights Offering. On September 27, 2013, we completed the Rights Offering issuing 3,329,234 shares of common stock for $1.50 per share for gross proceeds of approximately $5.0 million. We downstreamed the net proceeds to supplement the capital of FSGBank.

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The following table compares the required capital ratios maintained by First Security and FSGBank:



CAPITAL RATIOS

September 30, 2013	FSGBank Consent Order¹		Minimum Capital Requirements under Prompt Corrective Action Provisions		First Security		FSGBank
Tier 1 capital to risk adjusted assets	n/a		4.0	%	14.6	%	13.7	%
Total capital to risk adjusted assets	13.0	%	8.0	%	15.8	%	14.9	%
Leverage ratio	9.0	%	4.0	%	9.0	%	8.3	%
December 31, 2012
Tier 1 capital to risk adjusted assets	n/a		4.0	%	4.2	%	4.5	%
Total capital to risk adjusted assets	13.0	%	8.0	%	5.5	%	5.8	%
Leverage ratio	9.0	%	4.0	%	2.3	%	2.5	%
September 30, 2012
Tier 1 capital to risk adjusted assets	n/a		4.0	%	6.8	%	7.0	%
Total capital to risk adjusted assets	13.0	%	8.0	%	8.1	%	8.3	%
Leverage ratio	9.0	%	4.0	%	3.7	%	3.8	%

On July 2, 2013, the Federal Reserve approved final rules that substantially amend the regulatory risk-based capital rules applicable to the Company and the Bank. On July 9, 2013, the FDIC also approved, as an interim final rule, the regulatory capital requirements for U.S. banks, following the actions of the Federal Reserve. The final rules implement the “Basel III” regulatory capital reforms, as well as certain changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).

The final rules include new or increased risk-based capital requirements that will be phased in from 2015 to 2019. The rules add a new common equity Tier 1 capital to risk-weighted assets ratio minimum of 4.5%, increase the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0%, and decrease the Tier 2 capital that may be included in calculating total risk-based capital from 4.0% to 2.0%. The final rules also introduce a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets, which is in addition to the Tier 1 and total risk-based capital requirements. The required minimum ratio of total capital to risk-weighted assets will remain 8.0% and the minimum leverage ratio will remain 4.0%. The new risk-based capital requirements (except for the capital conservation buffer) will become effective for the Company on January 1, 2015. The capital conservation buffer will be phased in over four years beginning on January 1, 2016, with a maximum buffer of 0.625% of risk-weighted assets for 2016, 1.25% for 2017, 1.875% for 2018, and 2.5% for 2019 and thereafter. Failure to maintain the required capital conservation buffer will result in limitations on capital distributions and on discretionary bonuses to executive officers.

The following chart compares the risk-based capital ratios required under existing Federal Reserve rules to those prescribed under the new final rules described above:



	Current Rules	Final Rules
Common Equity Tier 1	not present	4.5%
Tier 1	4.0%	6.0%
Total Risk-Based Capital	8.0%	8.0%
Common Equity Tier 1 Capital Conservation Buffer	not present	2.5%

The final rules also implement revisions and clarifications consistent with Basel III regarding the various components of Tier 1 capital, including common equity, unrealized gains and losses and instruments that will no longer qualify as Tier 1 capital. The final rules also set forth certain changes for the calculation of risk-weighted assets that the Company will be required to implement beginning January 1, 2015.

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In addition to the updated capital requirements, the final rules also contain revisions to the prompt corrective action framework. Beginning January 1, 2015, the minimum ratios for the Bank to be considered well-capitalized will be updated as follows:



	Current Rules	Final Rules
Total Capital	10.0%	10.0%
Tier 1 Capital	6.0%	8.0%
Common Equity Tier 1 Capital	not present	6.5%
Leverage Ratio	5.0%	5.0%

Management is currently evaluating the provisions of the final rules and their expected impact on the Company. Based on the Company's current capital composition and levels, management does not presently anticipate that the final rules present a material risk to the Company's financial condition or results of operations.

EFFECTS OF GOVERNMENTAL POLICIES

We are affected by the policies of regulatory authorities, including the Federal Reserve Board and the OCC. An important function of the Federal Reserve Board is to regulate the national money supply.

Among the instruments of monetary policy used by the Federal Reserve Board are: purchases and sales of U.S. Government securities in the marketplace; changes in the discount rate, which is the rate any depository institution must pay to borrow from the Federal Reserve Board; and changes in the reserve requirements of depository institutions. These instruments are effective in influencing economic and monetary growth, interest rate levels and inflation.

The monetary policies of the Federal Reserve Board and other governmental policies have had a significant effect on the operating results of commercial banks in the past and are expected to continue to do so in the future. Because of changing conditions in the national and international economy and in the money market, as well as the result of actions by monetary and fiscal authorities, it is not possible to predict with certainty future changes in interest rates, deposit levels or loan demand or whether the changing economic conditions will have a positive or negative effect on operations and earnings.

Legislation from time to time is introduced in the United States Congress and the Tennessee General Assembly and other state legislatures, and regulations are proposed by the regulatory agencies that could affect our business. It cannot be predicted whether or in what form any of these proposals will be adopted or the extent to which our business may be affected thereby.

Dodd-Frank Act.

The bank regulatory landscape was dramatically changed by the Dodd-Frank Act, which was enacted on July 21, 2010 and which implements far-reaching regulatory reform. Among its many significant provisions, the Dodd-Frank Act:


•	established the Financial Stability Oversight Counsel made up of the heads of the various bank regulatory and other agencies to identify and respond to risks to U.S. financial stability arising from ongoing activities of large financial companies


•	established centralized responsibility for consumer financial protection by creating a new Consumer Financial Protection Bureau which will be responsible for implementing, examining and enforcing compliance with federal consumer financial laws with respect to financial institutions with over $10 billion in assets


•	required that banking agencies establish for most bank holding companies the same leverage and risk-based capital requirements as apply to insured depository institutions, and that bank holding companies and banks be well-capitalized and well managed in order to acquire banks located outside their home states


•	prohibits bank holding companies from including new trust preferred securities in their Tier 1 capital and, beginning with a three-year phase-in period on January 1, 2013, requires bank holding companies with assets over $15 billion to deduct existing trust preferred securities from their Tier 1 capital;

•

required the FDIC to set a minimum DIF reserve ratio of 1.35% and that the DIF reserve ratio be increased to that level by September 30, 2020; that FDIC off-set the effect of the higher minimum ratio on insured depository institutions with assets of less than $10 billion; and that FDIC change the assessment base used for calculating insurance assessments from the amount of insured deposits to average consolidated total assets minus average tangible equity;


•	established a permanent $250,000 limit for federal deposit insurance; provided separate, unlimited federal deposit insurance until December 31, 2012 for noninterest-bearing demand transaction accounts; and repealed the federal

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prohibition on the payment of interest on demand deposits, thereby permitting depository institutions to pay interest on business transaction and other accounts


•	amended the Electronic Fund Transfer Act to, among other things, give the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers having assets over $10 billion and to enforce a new statutory requirement that those fees be reasonable and proportional to the actual cost of a transaction to the issuer; an

•

required implementation of various corporate governance processes affecting areas such as executive compensation and proxy access by shareholders. Many provisions of the Dodd-Frank Act are subject to rulemaking by bank regulatory agencies and the SEC and will take effect over time, making it difficult to anticipate the overall financial impact on financial institutions and consumers. However, many provisions in the Dodd-Frank Act (including those permitting the payment of interest on demand deposits and restricting interchange fees) are likely to increase expenses and reduce revenues for all financial institutions.

Consumer Financial Protection Bureau (“CFPB”).

The Dodd-Frank Act created a new, independent federal agency, the CFPB, which was granted broad rulemaking, supervisory and enforcement powers under various federal consumer financial protection laws, including the laws referenced above, fair lending laws and certain other statutes

The CFPB has examination and primary enforcement authority with respect to depository institutions with $10 billion or more in assets, their service providers and certain non-depository entities such as debt collectors and consumer reporting agencies. Although FSGBank has less than $10 billion in assets, the impact of the formation of the CFPB has caused a ripple effect across all bank regulatory agencies, and placed a renewed focus on consumer protection and compliance efforts. For examples of this new authority, the CFPB has authority to prevent unfair, deceptive or abusive practices in connection with the offering of consumer financial products. The Dodd-Frank Act authorizes the CFPB to establish certain minimum standards for the origination of residential mortgages including a determination of the borrower's ability to repay. In addition, the Dodd-Frank Act allows borrowers to raise certain defenses to foreclosure if they receive any loan other than a “qualified mortgage” as defined by the CFPB. The Dodd-Frank Act permits states to adopt consumer protection laws and standards that are more stringent than those adopted at the federal level and, in certain circumstances, permits state attorneys general to enforce compliance with both the state and federal laws and regulations.

The CFPB has concentrated much of its rulemaking efforts on a variety of mortgage-related topics required under the Dodd-Frank Act, including mortgage origination disclosures, minimum underwriting standards and ability to repay, high-cost mortgage lending, and servicing practices. During 2012, the CFPB issued three proposed rulemakings covering loan origination and servicing requirements, which were finalized in January 2013, along with other rules on mortgages. The ability to repay and qualified mortgage standards rules, as well as the mortgage servicing rules, are scheduled to become effective in January 2014. The escrow and loan originator compensation rules became effective in June 2013. A final rule integrating disclosures required by the Truth in Lending Act and the Real Estate Settlement and Procedures Act will become effective in January 2014. We continue to analyze the impact that such rules may have on our business model, particularly with respect to our mortgage banking business.

RECENT ACCOUNTING PRONOUNCEMENTS

No significant new accounting guidance became effective for the nine months ended September 30, 2013. As of September 30, 2013 there was no issued guidance that is expected to have a significant impact on our consolidated financial statements when adopted.

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ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Market risk, with respect to us, is the risk of loss arising from adverse changes in interest rates and prices. The risk of loss can result in either lower fair market values or reduced net interest income. We manage several types of risk, such as credit, liquidity and interest rate. We consider interest rate risk to be a significant risk that could potentially have a large material effect on our financial condition. Further, we process hypothetical scenarios whereby we shock our balance sheet up and down for possible interest rate changes, we analyze the potential change (positive or negative) to net interest income, as well as the effect of changes in fair market values of assets and liabilities. We do not deal in international instruments, and therefore are not exposed to risks inherent to foreign currency. Additionally, as of September 30, 2013, we had no trading assets that exposed us to the risks in market changes.

Oversight of our interest rate risk management is the responsibility of the Asset/Liability Committee (ALCO). ALCO has established policies and limits to monitor, measure and coordinate our sources, uses and pricing of funds. In addition, as a result of the changes in executive management, an executive risk committee consisting of the Chief Executive Officer, Chief Financial Officer, Chief Credit Officer and Chief Administrative Officer has been established to monitor the various risks of First Security, including interest rate risk, and will report directly to the Audit and Enterprise Risk Management Committee of the Board of Directors.

Interest rate risk represents the sensitivity of earnings to changes in interest rates. As interest rates change, the interest income and expense associated with our interest sensitive assets and liabilities also change, thereby impacting net interest income, the primary component of our earnings. ALCO utilizes the results of both static gap and income simulation reports to quantify the estimated exposure of net interest income to a sustained change in interest rates.

Our income simulation analysis projected net interest income based on a decline in interest rates of 100 basis points (i.e. 1.00%) and an increase of 100 basis points and 200 basis points (1.00% and 2.00%, respectively) over a twelve-month period. Given this scenario, as of September 30, 2013, we had an exposure to falling rates and a benefit from rising rates. More specifically, our model forecasts a decline in net interest income of $3.3 million, or 14.5%, as a result of a 100 basis point decline in rates based on annualizing our financial results through September 30, 2013. The model predicts a $838 thousand increase in net interest income resulting from a 100 basis point increase in rates. Finally, the model also forecasts an $1.7 million increase in net interest income, or 7.6%, as a result of a 200 basis point increase in rates.

The following chart reflects our sensitivity to changes in interest rates as indicated as of September 30, 2013. The numbers are based on a static balance sheet, and the chart assumes that pay downs and maturities of both assets and liabilities are reinvested in like instruments at current interest rates.

INTEREST RATE RISK

INCOME SENSITIVITY SUMMARY



	Down 100 BP			Current			Up 100 BP			Up 200 BP
	(in thousands, except percentages)
Annualized net interest income¹	$	19,316		$	22,586		$	23,424		$	24,314
Dollar change net interest income	(3,270		)	—			838			1,728
Percentage change net interest income	(14.48		)%	0.00		%	3.71		%	7.65		%

__________________


^1.	Annualized net interest income is a twelve month projection based on year-to-date results.

The preceding sensitivity analysis is a modeling analysis, which changes periodically and consists of hypothetical estimates based upon numerous assumptions including interest rate levels, shape of the yield curve, prepayments on loans and securities, rates on loans and deposits, reinvestments of paydowns and maturities of loans, investments and deposits, and other assumptions. In addition, there is no input for growth or a change in asset mix. While assumptions are developed based on the current economic and market conditions, we cannot make any assurances as to the predictive nature of these assumptions, including how customer preferences or competitor influences might change.

As market conditions vary from those assumed in the sensitivity analysis, actual results will differ. Also, the sensitivity analysis does not reflect actions that we might take in responding to or anticipating changes in interest rates.

We use the Sendero Vision Asset/Liability system, which is a comprehensive interest rate risk measurement tool that is widely used in the banking industry. Generally, it provides the user with the ability to more accurately model both static and dynamic gap, economic value of equity, duration and income simulations using a wide range of scenarios including interest rate shocks and rate ramps. The system also models derivative instruments.

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ITEM 4.	CONTROLS AND PROCEDURES

As of the end of the period covered by this Quarterly Report on Form 10-Q, our principal executive officer and principal financial officer have evaluated the effectiveness of our “disclosure controls and procedures” (“Disclosure Controls”).

Disclosure Controls, as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), are procedures that are designed with the objective of ensuring that information required to be disclosed in our reports filed under the Exchange Act, such as this Annual Report, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Disclosure Controls are also designed with the objective of ensuring that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure.

Our management, including the CEO and CFO, does not expect that our Disclosure Controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions.

Our CEO and CFO have concluded that our Disclosure Controls were effective at a reasonable assurance level as of September 30, 2013.

Changes in Internal Controls

There have been no changes in our internal controls over financial reporting during the fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.

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PART II - OTHER INFORMATION


ITEM 1.	LEGAL PROCEEDINGS

In the normal course of business, we are at times subject to pending and threatened legal actions. Although we are not able to predict the outcome of such actions, after reviewing pending and threatened actions with counsel, we believe that the outcome of any or all such actions will not have a material adverse effect on our business, financial condition and/or operating results.


ITEM 1A.	RISK FACTORS

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2012 as well as the additional risk factor below, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

The Federal Reserve has adopted new capital requirements for financial institutions that may require us to retain or raise additional capital and/or reduce dividends.

On July 2, 2013, the Federal Reserve adopted final rules that, when effective, will increase regulatory capital requirements, implement changes required by the Dodd-Frank Act and implement portions of the Basel III regulatory capital reforms. In the future, the capital requirements for bank holding companies may require us to retain or raise additional capital, restrict our ability to pay dividends and repurchase shares of our common stock, restrict our ability to provide certain forms of discretionary executive compensation and/or require other changes to our strategic plans. While we believe our current capital levels would be adequate under the new rules, the impact of these rules cannot yet be fully understood. The rules could restrict our ability to grow and implement our future business strategies, which could have an adverse impact on our results of operations.


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

Not applicable.


ITEM 3.	DEFAULTS UPON SENIOR SECURITIES

Not applicable.


ITEM 4.	MINE SAFETY DISCLOSURES

Not applicable.


ITEM 5.	OTHER INFORMATION

Not applicable.

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ITEM 6.	EXHIBITS




EXHIBIT NUMBER	DESCRIPTION


10.1	Form of Restricted Stock Award for an Employee under the 2012 Long-Term Incentive Plan, incorporated by reference to the Exhibit 10.1 to the Current Report on Form 8-K filed with the SEC on July 26, 2013.

10.2	Form of Restricted Stock Award for a Director under the 2012 Long-Term Incentive Plan, incorporated by reference to the Exhibit 10.2 to the Current Report on Form 8-K filed with the SEC on July 26, 2013.
31.1	Certification of Principal Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934

31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934

32.1	Certification of Principal Executive Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934

32.2	Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Rule 13a-14(b) under the Securities Exchange Act of 1934

101	Interactive Data Files providing financial information from the Registrant’s Quarterly Report on Form 10-Q for the quarter ended September 30, 2013 in XBRL (eXtensible Business Reporting Language). Pursuant to Regulation 406T of Regulation S-T, these interactive data files are deemed not filed or part of a registration statement or prospectus for purposes of Section 11 or 12 of the Securities Act of 1933, as amended, or Section 18 of the Securities Exchange Act of 1934, as amended, and are otherwise not subject to liability.

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SIGNATURES

Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed by the undersigned, thereunto duly authorized.



	FIRST SECURITY GROUP, INC.
	(Registrant)

November 13, 2013	/s/ D. MICHAEL KRAMER
	D. Michael Kramer
	Chief Executive Officer

November 13, 2013	/s/ JOHN R. HADDOCK
	John R. Haddock
	Chief Financial Officer