United States

Securities and Exchange Commission

Washington, D.C. 20549

FORM 10-Q

(MARK ONE)

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE ~~SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2013~~

~~o TRANSITION~~SECURITIES ~~REPORT~~EXCHANGE ~~UNDER~~ACT ~~SECTION~~OF 131934 ORFOR ~~15(d) OF~~ THE ~~SECURITIES~~QUARTERLY ~~EXCHANGE~~PERIOD ~~ACT OF 1934~~ENDED

~~1ST~~JUNE ~~FINANCIAL~~30, ~~SERVICES CORPORATION (Exact name of the registrant as specified in its charter)~~2013

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

o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

1ST FINANCIAL SERVICES CORPORATION

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

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

101 Jack Street

Hendersonville, North Carolina 28792

(Address of Principal Executive Office)

(828) 697-3100

(Registrant’s telephone number, including area code)

Not Applicable

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 of 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

YES þ NO o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

YES þ NO o

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

Large accelerated filer o Accelerated filer o Non-accelerated filer o Smaller reporting company þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

YES o NO þ

Common Stock, $5 par value

5,~~204~~202,385 shares outstanding as of ~~May~~August 1, 2013

1st Financial Services Corporation

			Page Number
Part I. FINANCIAL INFORMATION
	Item 1.	Financial Statements		1
		Consolidated Balance Sheets as of March 31, 2013 (Unaudited) and December 31, 2012		1
		Consolidated Statements of Operations for the Three Months Ended March 31, 2013 and 2012 (Unaudited)		2
		Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2013 and 2012 (Unaudited)		3
		Consolidated Statements of Changes in Stockholders’ Equity for the Three Months Ended March 31, 2013 and 2012 (Unaudited)		4
		Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2013 and 2012 (Unaudited)		5
		Notes to Consolidated Financial Statements (Unaudited)		6-36
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		37-59
	Item 3.	Quantitative and Qualitative Disclosures about Market Risk		60
	Item 4.	Controls and Procedures		60
Part II. OTHER INFORMATION
	Item 1.	Legal Proceedings		61
	Item 1A.	Risk Factors		61
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		61
	Item 3.	Defaults Upon Senior Securities		61
	Item 4.	Mine Safety Disclosures		61
	Item 5.	Other Information		61
	Item 6.	Exhibits		61
Signatures				62

Index

Part I. FINANCIAL INFORMATION		Page Number

Item 1.	Financial Statements		1

	Consolidated Balance Sheets as of June 30, 2013 (Unaudited) and December 31, 2012		1

	Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2013 and 2012 (Unaudited)		2

	Consolidated Statements of Comprehensive Income (Loss) for the Three and Six Months Ended June 30, 2013 and 2012 (Unaudited)		3

	Consolidated Statements of Changes in Stockholders’ Equity for the Six Months Ended June 30, 2013 and 2012 (Unaudited)		4

	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2013 and 2012 (Unaudited)		5

	Notes to Consolidated Financial Statements (Unaudited)		6-37

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		38-63

Item 3.	Quantitative and Qualitative Disclosures about Market Risk		64

Item 4.	Controls and Procedures		64

Part II. Other Information

Item 1.	Legal Proceedings		65

Item 1A.	Risk Factors		65

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds		65

Item 3.	Defaults Upon Senior Securities		65

Item 4.	Mine Safety Disclosures		65

Item 5.	Other Information		65

Item 6.	Exhibits		65

Signatures			66

Back to "Table of Contents"

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

1st Financial Services Corporation Consolidated Balance Sheets March 31, 2013 (Unaudited) and December 31, 2012

1st Financial Services Corporation
Consolidated Balance Sheets
June 30, 2013 (Unaudited) and December 31, 2012

(dollars in thousands, except share and per share data)	June 30 2013			December 31 2012
Assets
Cash and noninterest-bearing bank deposits	$	9,327		$	9,710
Due from Federal Reserve Bank		27,158			26,503
Interest-bearing deposits with banks		1,444			2,435
Total cash and cash equivalents		37,929			38,648
Investment securities available for sale		104,542			253,829
Investment securities held to maturity (fair value of $146,937 at June 30, 2013
and $1,250 at December 31, 2012)		156,743			1,250
Restricted equity securities		3,105			3,052
Loans held for sale		2,549			5,805
Portfolio loans		363,355			387,657
Allowance for loan losses		(10,564	)		(10,690	)
Net portfolio loans		352,791			376,967
Bank-owned life insurance		13,498			13,326
Property and equipment, net		4,152			4,410
Accrued interest receivable		2,288			2,343
Foreclosed real estate		13,585			9,821
Other assets		903			980
Total assets	$	692,085		$	710,431

Liabilities and Stockholders’ Equity
Liabilities
Demand deposits	$	85,556		$	85,959
NOW accounts		70,313			71,685
Savings deposits		166,676			169,031
Money market accounts		60,261			60,868
Time deposits under $100		138,198			144,687
Time deposits of $100 and greater		147,875			151,610
Total deposits		668,879			683,840
Federal funds purchased and securities sold under
agreements to repurchase		668			436
Accrued interest payable		537			822
Other liabilities		3,012			5,651
Total liabilities		673,096			690,749

Stockholders’ equity
Preferred stock, no par value. 10,000,000 shares authorized; 16,369 shares
issued and outstanding		16,293			16,192
Common stock, $5.00 par value. 35,000,000 shares authorized;
5,202,385 and 5,204,385 shares issued and outstanding at June 30, 2013
and December 31, 2012, respectively		26,012			26,022
Common stock warrant		1,016			1,016
Additional paid-in capital		17,001			16,993
Retained deficit		(39,119	)		(41,178	)
Accumulated other comprehensive income (loss)		(2,214	)		637
Total stockholders’ equity		18,989			19,682
Total liabilities and stockholders’ equity	$	692,085		$	710,431

See accompanying notes to consolidated financial statements

(dollars in thousands, except share and per share data)	March 31 2013			December 31 2012
Assets
Cash and noninterest-bearing bank deposits	$	6,923		$	9,710
Due from Federal Reserve Bank		31,928			26,503
Interest-bearing deposits with banks		2,217			2,435
Total cash and cash equivalents		41,068			38,648
Investment securities available for sale		248,745			253,829
Investment securities held to maturity (fair value of $1,250 at March 31, 2013
and December 31, 2012)		1,250			1,250
Restricted equity securities		2,855			3,052
Loans held for sale		3,142			5,805
Portfolio loans		374,634			387,657
Allowance for loan losses		(10,787	)		(10,690	)
Net portfolio loans		363,847			376,967
Bank-owned life insurance		13,414			13,326
Property and equipment, net		4,310			4,410
Accrued interest receivable		2,352			2,343
Foreclosed real estate		15,733			9,821
Other assets		747			980
Total assets	$	697,463		$	710,431
Liabilities and Stockholders’ Equity
Liabilities
Demand deposits	$	84,570		$	85,959
NOW accounts		70,265			71,685
Savings deposits		170,049			169,031
Money market accounts		60,623			60,868
Time deposits under $100		140,426			144,687
Time deposits of $100 and greater		145,367			151,610
Total deposits		671,300			683,840
Federal funds purchased and securities sold under
agreements to repurchase		408			436
Accrued interest payable		527			822
Other liabilities		5,505			5,651
Total liabilities		677,740			690,749
Stockholders’ equity
Preferred stock, no par value. 10,000,000 shares authorized; 16,369 shares
issued and outstanding		16,242			16,192
Common stock, $5.00 par value. 35,000,000 shares authorized;
5,204,385 shares issued and outstanding at March 31, 2013
and December 31, 2012		26,022			26,022
Common stock warrant		1,016			1,016
Additional paid-in capital		16,998			16,993
Retained deficit		(40,753	)		(41,178	)
Accumulated other comprehensive income		198			637
Total stockholders’ equity		19,723			19,682
Total liabilities and stockholders’ equity	$	697,463		$	710,431

See accompanying notes to consolidated financial statements

~~1st~~Back ~~Financial~~to ~~Services~~"Table ~~Corporation Consolidated Statements~~ of ~~Operations Three Months Ended March 31, 2013 and 2012 (Unaudited)~~Contents"

	Three Months Ended March 31
1st Financial Services Corporation
(dollars in thousands, except per share data)	2013		2012
Consolidated Statements of Operations
Interest income
Three and Six Months Ended June 30, 2013 and 2012 (Unaudited)
Loans and fees on loans	$	4,599	$	5,364
	Three Months Ended June 30				Six Months Ended June 30
Investment securities		1,364		1,151
(dollars in thousands, except per share data)	2013		2012		2013		2012
Due from Federal Reserve Bank		16		14
Interest income
Interest-earning deposits with banks		4		15
Loans and fees on loans	$	4,472	$	5,120	$	9,071	$	10,484
Total interest income		5,983		6,544
Investment securities		1,263		1,275		2,627		2,426
Interest expense
Due from Federal Reserve Bank		19		21		35		35
Deposits		1,027		1,597
Interest-earning deposits with banks		3		14		7		29
Federal funds purchased and securities sold under
Total interest income		5,757		6,430		11,740		12,974
agreements to repurchase		-		1
Interest expense
Total interest expense		1,027		1,598
Deposits		998		1,506		2,025		3,103
Net interest income		4,956		4,946
Federal funds purchased and securities sold under
Provision for loan losses		940		1,105
agreements to repurchase		1		-		1		1
Net interest income after provision for loan losses		4,016		3,841
Total interest expense		999		1,506		2,026		3,104
Noninterest income
Net interest income		4,758		4,924		9,714		9,870
Service charges on deposit accounts		312		357
Provision for loan losses		-		935		940		2,040
Mortgage services revenue		663		623
Net interest income after provision for loan losses		4,758		3,989		8,774		7,830
Other service charges and fees		393		407
Noninterest income
Increase in cash surrender value of life insurance		87		99
Service charges on deposit accounts		317		370		629		727
Gains on sales of investment securities, net		44		679
Mortgage services revenue		493		618		1,156		1,241
USDA/SBA loan sale and servicing revenue		2		564
Other service charges and fees		435		430		828		837
Other income		92		57
Increase in cash surrender value of life insurance		84		96		171		195
Total noninterest income		1,593		2,786
Gains on sales of investment securities, net		168		605		212		1,284
Noninterest expense
USDA/SBA loan sale and servicing revenue		2		28		4		592
Salaries and employee benefits		2,425		2,395
Other income		117		87		209		144
Occupancy		335		343
Total noninterest income		1,616		2,234		3,209		5,020
Equipment		192		202
Noninterest expense
Advertising		50		49
Salaries and employee benefits		2,349		2,467		4,774		4,862
Data processing and telecommunications		512		469
Occupancy		331		343		666		686
Deposit insurance premiums		606		616
Equipment		200		212		392		414
Professional fees		90		92
Advertising		57		59		107		108
Printing and supplies		25		28
Data processing and telecommunications		491		464		1,003		933
Foreclosed assets		475		1,345
Deposit insurance premiums		596		604		1,202		1,220
Dues and subscriptions		30		34
Professional fees		56		138		146		227
Postage		40		52
Printing and supplies		24		28		49		56
Loan related expense		95		248
Foreclosed assets		21		1,016		496		2,361
Corporate insurance		132		48
Dues and subscriptions		33		38		63		72
Other		127		122
Postage		44		51		84		103
Total noninterest expense		5,134		6,043
Loan related expense		159		201		254		449
Income before income taxes		475		584
Corporate insurance		125		76		257		124
Income tax expense		-		-
Other		203		179		330		304
Net income		475		584
Total noninterest expense		4,689		5,876		9,823		11,919
Accretion of preferred stock to redemption value		50		50
Income before income taxes		1,685		347		2,160		931
Dividends on preferred stock		204		204
Income tax expense		-		-		-		-
Net income available to common stockholders	$	221	$	330
Net income		1,685		347		2,160		931
Basic net income per common share	$	0.04	$	0.06
Accretion of preferred stock to redemption value		51		51		101		101
Diluted net income per common share	$	0.04	$	0.06
Dividends on preferred stock		205		205		409		409
Basic weighted-average common shares outstanding		5,204,385		5,183,117
Net income available to common stockholders	$	1,429	$	91	$	1,650	$	421
Diluted weighted-average common shares outstanding		5,204,385		5,183,117
Basic net income per common share	$	0.27	$	0.02	$	0.32	$	0.08
Diluted net income per common share	$	0.27	$	0.02	$	0.32	$	0.08
Basic weighted-average common shares outstanding		5,203,836		5,200,388		5,204,109		5,191,753
Diluted weighted-average common shares outstanding		5,203,836		5,200,388		5,204,109		5,191,753

See accompying notes to consolidated financial statements

~~1st~~Back ~~Financial~~to ~~Services~~"Table ~~Corporation Consolidated Statements~~ of ~~Comprehensive Income Three Months Ended March 31, 2013 and 2012~~Contents"

	Three Months Ended March 31
1st Financial Services Corporation
(dollars in thousands)	2013			2012
Consolidated Statements of Comprehensive Income (Loss)
Net income	$	475		$	584
Three and Six Months Ended June 30, 2013 and 2012 (Unaudited)
Other comprehensive loss, before tax
	Three Months Ended June 30						Six Months Ended June 30
Investment securities available for sale
(dollars in thousands)	2013			2012			2013			2012
Change in net unrealized gains during the period		(670	)		(124	)
Net income	$	1,685		$	347		$	2,160		$	931
Reclassification adjustment for gains on sales included in net income		(44	)		(679	)
Other comprehensive income (loss), before tax
Other comprehensive loss, before tax		(714	)		(803	)
Investment securities available for sale
Benefit for income taxes related to items of other comprehensive loss		(275	)		(310	)
Change in net unrealized gains (losses) during the period		(2,369	)		139			(3,039	)		(1,342	)
Other comprehensive loss, net of tax		(439	)		(493	)
Reclassification adjustment for securities transferred during the period		(412	)		-			(412	)		-
Comprehensive income	$	36		$	91
Reclassification adjustment for gains on sales included in net income		(168	)		605			(212	)		1,284
Net unrealized gains (losses) on investment securities available for sale		(2,949	)		744			(3,663	)		(58	)
Net unrealized holding gains on securities transferred from available for sale
to held-to-maturity, net of amortization and accretion		412			-			412			-
Other comprehensive income (loss), before tax		(2,537	)		744			(3,251	)		(58	)
Income tax expense (benefit) related to items of other comprehensive income (loss)		(125	)		287			(400	)		(22	)
Other comprehensive income (loss), net of tax		(2,412	)		457			(2,851	)		(36	)
Comprehensive income (loss)	$	(727	)	$	804		$	(691	)	$	895

See accompanying notes to consolidated financial statements

~~1st~~Back ~~Financial~~to ~~Services~~"Table ~~Corporation Consolidated Statements~~ of ~~Changes in Stockholders’ Equity Three Months Ended March 31, 2013 and 2012 (Unaudited)~~Contents"

(dollars in thousands, except share data)
																			Accumulated
																			Other
													Additional						Comprehensive
	Common Stock								Preferred Stock				Paid-in			Retained			Income
	Shares			Amount			Warrant		Shares		Amount		Capital			Deficit			(Loss)			Total
Balance, December 31, 2011		5,168,546		$	25,843		$	1,016		16,369	$	15,989	$	17,173		$	(42,245	)	$	766		$	18,542
Issuance of common stock
pursuant to restricted stock
plan		43,244			216			-		-		-		(216	)		-			-			-
Forfeiture of nonvested stock
options		(21,507	)		(108	)		-		-		-		85			-			-			(23	)
Compensation expense related
to restricted stock plan		-			-			-		-		-		9			-			-			9
Accretion of preferred stock to
redemption value		-			-			-		-		50		-			(50	)		-			-
Net income		-			-			-		-		-		-			584			-			584
Other comprehensive loss, net
of tax		-			-			-		-		-		-			-			(493	)		(493	)
Balance, March 31, 2012		5,190,283		$	25,951		$	1,016		16,369	$	16,039	$	17,051		$	(41,711	)	$	273		$	18,619
Balance, December 31, 2012		5,204,385		$	26,022		$	1,016		16,369	$	16,192	$	16,993		$	(41,178	)	$	637		$	19,682
Compensation expense related
to restricted stock plan		-			-			-		-		-		5			-			-			5
Accretion of preferred stock to
redemption value		-			-			-		-		50		-			(50	)		-			-
Net income		-			-			-		-		-		-			475			-			475
Other comprehensive loss, net
of tax		-			-			-		-		-		-			-			(439	)		(439	)
Balance, March 31, 2013		5,204,385		$	26,022		$	1,016		16,369	$	16,242	$	16,998		$	(40,753	)	$	198		$	19,723

1st Financial Services Corporation

Consolidated Statements of Changes in Stockholders’ Equity

Six Months Ended June 30, 2013 and 2012 (Unaudited)

(dollars in thousands, except share data)
																			Accumulated
																			Other
													Additional						Comprehensive
	Common Stock								Preferred Stock				Paid-in			Retained			Income
	Shares			Amount			Warrant		Shares		Amount		Capital			Deficit			(Loss)			Total
Balance, December 31, 2011		5,168,546		$	25,843		$	1,016		16,369	$	15,989	$	17,173		$	(42,245	)	$	766		$	18,542
Issuance of common stock pursuant to restricted stock plan		86,488			432			-		-		-		(432	)		-			-			-
Common stock cancelled pursuant to restricted stock plan		(40,552	)		(203	)		-		-		-		167			-			-			(36	)
Compensation expense related to restricted stock plan		-			-			-		-		-		18			-			-			18
Accretion of preferred stock to redemption value		-			-			-		-		101		-			(101	)		-			-
Net income		-			-			-		-		-		-			931			-			931
Other comprehensive loss, net of tax		-			-			-		-		-		-			-			(36	)		(36	)
Balance, June 30, 2012		5,214,482		$	26,072		$	1,016		16,369	$	16,090	$	16,926		$	(41,415	)	$	730		$	19,419

Balance, December 31, 2012		5,204,385		$	26,022		$	1,016		16,369	$	16,192	$	16,993		$	(41,178	)	$	637		$	19,682
Common stock cancelled pursuant to restricted stock plan		(2,000	)		(10	)		-		-		-		-			-			-			(10	)
Compensation expense related to restricted stock plan		-			-			-		-		-		8			-			-			8
Accretion of preferred stock to redemption value		-			-			-		-		101		-			(101	)		-			-
Net income		-			-			-		-		-		-			2,160			-			2,160
Other comprehensive loss, net of tax		-			-			-		-		-		-			-			(2,851	)		(2,851	)
Balance, June 30, 2013		5,202,385		$	26,012		$	1,016		16,369	$	16,293	$	17,001		$	(39,119	)	$	(2,214	)	$	18,989

See accompanying notes to consolidated financial statements

~~1st~~Back ~~Financial~~to ~~Services~~"Table ~~Corporation Consolidated Statements~~ of ~~Cash Flows Three Months Ended March 31, 2013 and 2012 (Unaudited)~~Contents"

	Three Months Ended March 31
1st Financial Services Corporation
Consolidated Statements of Cash Flows
Six Months Ended June 30, 2013 and 2012 (Unaudited)
	Six Months Ended June 30
(dollars in thousands)	2013			2012
Cash flows from operating activities
Net income	$	~~475~~2,160		$	~~584~~931
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation		~~202~~400			~~225~~446
Provision for loan losses		940			12,~~105~~040
Amortization of premium on securities, net of discount accretion		~~166~~449			~~353~~681
Origination of held-for-sale loans		(2343,~~538~~594	)		(2145,~~295~~057	)
Proceeds from sales of held-for-sale loans		2647,~~816~~894			2551,~~728~~316
Net gains on sales of investment securities		(44212	)		(~~679~~1,284	)
Net gains on sales of USDA and SBA loans		-			(~~481~~577	)
Net gains on sales of held-for-sale loans		(~~615~~1,044	)		(~~535~~1,100	)
Net (gains) losses on sales of foreclosed real estate		(75488	)		~~201~~145
Net gains on sales of repossessed assets		-			(5257	)
Net losses on sale or disposal of equipment		35			3536
Stock compensation expense (benefit)		5(2	)		(1418	)
Writedowns of foreclosed real estate		~~299~~502			~~267~~503
Writedowns of repossessed assets		-			~~467~~821
Increase in cash surrender value of bank-owned life insurance		(88171	)		(99195	)
Changes in assets and liabilities:
Accrued interest receivable		(955	)		2935
Other assets		~~233~~76			(~~113~~1,170	)
Accrued interest payable		(~~295~~285	)		(~~207~~289	)
Other liabilities		~~130~~(240	)		~~864~~200
Net cash provided by operating activities		46,~~605~~445			67,~~383~~407
Cash flows from investing activities
Purchases of investment securities available for sale		(26,789	)		(51,335	)
Purchases of investment securities available-for-sale		(57,737	)		(152,098	)
Sales of investment securities available for sale		8,997			15,197
Sales of investment securities available-for-sale		15,925			42,844
Maturities of investment securities available for sale		2,539			4,553
Calls of investment securities available-for-sale		31,500			61,833
Calls of investment securities available for sale		19,500			16,992
Maturities of investment securities available-for-sale		7,517			9,772
Redemptions of restricted equity securities		197			-
Purchases of investment securities held-to-maturity		(9,007	)		-
Purchases of restricted equity securities		-			(188	)
Maturities of investment securities held-to-maturity		109			-
Proceeds from sales of foreclosed real estate		854			1,525
Purchases of restricted equity securities		(250	)		(187	)
Proceeds from sales of repossessed assets		-			1,833
Redemptions of restricted equity securities		197			807
Proceeds from sales of USDA and SBA loans		-			5,941
Proceeds from sales of foreclosed real estate		3,392			10,161
Net decrease in loans		5,190			7,509
Improvements to foreclosed real estate		(98	)		-
Purchases of property and equipment		(105	)		(128	)
Proceeds from sales of repossessed assets		-			2,640
Net cash provided by investing activities		10,383			1,899
Proceeds from sales of USDA and SBA loans		-			5,563
Net decrease in loans		16,164			11,087
Purchases of property and equipment		(147	)		(146	)
Net cash provided by (used in) investing activities		7,565			(7,724	)
Cash flows from financing activities
Net increase (decrease) in deposits		(1214,~~540~~961	)		417,~~398~~406
Net decrease in securities sold under agreements to repurchase and
Net increase (decrease) in securities sold under agreements to repurchase and
federal funds purchased		~~(28~~232	)		(34100	)
Repayment of FHLB advances		-			(3,952	)
Net cash provided by (used by) financing activities		(12,568	)		412
Net cash provided by (used in) financing activities		(14,729	)		13,354
Net increase in cash and cash equivalents		2,420			8,694
Net increase (decrease) in cash and cash equivalents		(719	)		13,037
Cash and cash equivalents, beginning of period		38,648			37,303
Cash and cash equivalents, end of period	$	4137,~~068~~929		$	4550,~~997~~340
Supplemental disclosure of cash flow information
Transfer of loans to foreclosed real estate	$	67,~~990~~072		$	14,~~514~~230
Transfer of loans to repossessed assets		-			2,~~544~~586
Transfer of held-to-maturity securities to available-for-sale securities		-			2,917
Transfer of available-for-sale securities to held-to-maturity securities		146,587			-

See accompanying notes to consolidated financial statements

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Note 1 - Summary of Significant Accounting Policies

Business and Basis of Presentation

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

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

The accounting and reporting policies of the Company and the Bank follow generally accepted accounting principles and general practices within the financial services industry. Following is a summary of the more significant policies.

Business Segments

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

Principles of Consolidation

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

Basis of Presentation

The accompanying unaudited consolidated financial statements were prepared in accordance with instructions for Form 10-Q and therefore do not include all disclosures required by generally accepted accounting principles for a complete presentation of financial statements. In the opinion of management, the consolidated financial statements contain all adjustments necessary to present fairly the financial condition of the Company as of ~~March~~June 3130, 2013, its results of operations, and other comprehensive income, ~~changes~~(loss) infor ~~stockholders’~~the ~~equity~~three- and six-month periods ended June 30, 2013 and 2012, and its cash flows and changes in stockholders’ equity for the ~~three~~six-month periods ended ~~March~~June 3130, 2013 and 2012.

Management believes all interim period adjustments are of a normal recurring nature. These consolidated financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 2012, contained in the Company’s filing on Form 10-K with the Securities and Exchange Commission. The accounting policies of the Company and the Bank follow generally accepted accounting principles and practices within the financial services industry.

Estimates

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

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

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

Reclassifications

Certain amounts in the 2012 consolidated financial statements were reclassified to conform to the 2013 presentation. These reclassifications had no effect on stockholders’ equity or results of operations as previously presented.

Risk and Uncertainties

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

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

Subsequent Events

In preparing these financial statements, the Company has evaluated events and transactions through our filing date for potential recognition or disclosure in the consolidated financial statements.

Recent Accounting Developments

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

~~Disclosures~~The ~~about~~Comprehensive ~~Troubled~~Income ~~Debt~~topic ~~Restructurings~~of the Accounting Standards Codification (~~TDRs~~ASC) was amended in June 2011. The amendment eliminated the option to present other comprehensive income as a part of the statement of changes in stockholders’ equity and required byconsecutive ~~Accounting~~presentation ~~Standards~~of ~~Update~~the ~~(ASU)~~statement ~~2010-20~~of net income and other comprehensive income. The amendments were ~~deferred~~applicable byto the Company January 1, 2012 and have been applied retrospectively. In December 2011, the topic was further amended to defer the effective date of presenting reclassification adjustments from other comprehensive income to net income on the face of the financial statements while the FASB redeliberated the presentation requirements for the reclassification adjustments. In February 2013, the Financial Accounting Standards Board (FASB) infurther ~~ASU~~amended ~~2011-01~~the ~~issued~~Comprehensive inIncome ~~January~~topic ~~2011~~clarifying the conclusions from such redeliberations. Specifically, Inthe ~~April~~amendments ~~2011~~do not change the ~~FASB~~current ~~issued~~requirements ~~ASU~~for ~~2011-02~~reporting net income or other comprehensive income in financial statements. However, the amendments do require an entity to ~~assist~~provide ~~creditors~~information ~~with~~about ~~their~~the ~~determination~~amounts reclassified out of ~~when~~accumulated aother ~~restructuring~~comprehensive isincome aby ~~TDR~~component. In ~~The~~addition, ~~determination~~in certain circumstances an entity is ~~based~~required to present, either on ~~whether~~the face of the ~~restructuring~~statement ~~constitutes~~where anet ~~concession~~income ~~and~~is ~~whether~~presented or in the ~~debtor~~notes, issignificant ~~experiencing~~amounts ~~financial~~reclassified ~~difficulties~~out asof ~~both~~accumulated ~~events~~other ~~must~~comprehensive beincome ~~present~~by the respective line items of net income. The ~~Disclosures~~amendments ~~related~~became toeffective ~~TDRs~~for ~~under~~the ~~ASU~~Company ~~2010-20~~on a prospective basis for reporting periods beginning after December 15, 2012 and did not have ~~been~~a ~~presented~~material ineffect ~~Note~~on 5its financial statements.

In April 2011, the criteria used to determine effective control of transferred assets in the Transfers and Servicing topic of the Accounting Standards Certification (ASC) was amended by ASU 2011-03. The requirement for the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms and the collateral maintenance implementation guidance related to that criterion were removed from the assessment of effective control. The other criteria to assess effective control were not changed. The amendments were effective for the Company beginning January 1, 2012, and had no material effect on the financial statements.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

~~The~~On ~~Comprehensive~~April ~~Income~~22, ~~topic~~2013, the FASB issued guidance addressing application of the ~~ASC~~liquidation ~~was~~basis ~~amended~~of inaccounting. The ~~June~~guidance ~~2011.~~is ~~The~~intended ~~amendment~~to ~~eliminates~~clarify when an entity should apply the ~~option~~liquidation tobasis ~~present~~of ~~other~~accounting. In ~~comprehensive~~addition, ~~income~~the asguidance aprovides ~~part~~principles offor the ~~statement~~recognition and measurement of ~~changes~~assets inand ~~stockholders’~~liabilities ~~equity.~~and ~~The~~requirements ~~amendment~~for ~~requires~~financial ~~consecutive~~statements ~~presentation~~prepared ofusing the ~~statement~~liquidation basis of ~~net~~accounting. The ~~income~~amendments ~~and~~will ~~other~~be ~~comprehensive~~effective ~~income~~for ~~and~~entities ~~requires~~that andetermine ~~entity~~liquidation tois ~~present~~imminent ~~reclassification~~during ~~adjustments~~annual ~~from~~reporting ~~other~~periods ~~comprehensive~~beginning ~~income~~after toDecember ~~net~~15, ~~income~~2013, onand ~~the~~interim ~~face~~reporting ofperiods ~~the~~therein ~~financial~~and ~~statements.~~those ~~The~~requirements ~~amendment~~should ~~was~~be ~~applicable~~applied toprospectively from the ~~Company~~day onliquidation ~~January~~becomes 1,imminent. Early ~~2012,~~adoption ~~and~~is ~~was~~permitted. The ~~applied~~Company ~~retrospectively.~~does ~~The~~not ~~amendment~~expect ~~had~~these noamendments ~~material~~to have any effect on ~~the~~its financial statements.

The FASB amended the Comprehensive Income topic of the ASC in February 2013. The amendment addresses reporting of amounts reclassified out of accumulated other comprehensive income. Specifically, the amendment does not change the current requirements for reporting net income or other comprehensive income in financial statements. However, the amendment does require an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component. In addition, in certain circumstances, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income. The amendment was effective for the Company for reporting periods beginning after December 15, 2012. The amendment had no material effect on the financial statements.

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

Note 2 - Enforcement Actions and Going Concern Considerations

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

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

●

enhance its supervision of the Bank’s activities.

●

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

●

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

●

strengthen the Allowance policy of the Bank.

●

develop and implement a strategic plan.

●

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

●

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

●

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

●

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

● adopt a loan review and grading system. ● develop a plan to systematically reduce the concentration in a limited group of borrowers.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

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

●

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

	●		implement a plan and 2010 budget designed to improve and sustain earnings.
	●		implement internal routine and control policies addressing concerns to enhance its safe and sound operation.
	●		implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.

●

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

●

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

●

limit growth to 10% per year.

●

not pay dividends without prior approval.

●

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

●

correct any violations of laws and regulations.

●

make quarterly progress reports.

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

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

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

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

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

●	not declare or pay any dividends without approval.

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

● not directly or indirectly, incur, increase, or guarantee any debt without approval.

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

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

●	not directly or indirectly, incur, increase, or guarantee any debt without approval.

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

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

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

The Company and the Bank have taken and continue to take action to respond to the issues raised in the Consent Order and the Written Agreement.

Going Concern Considerations

The going concern assumption is a fundamental principle in the preparation of financial statements. It is the responsibility of management to assess the Company’s ability to continue as a going concern. In assessing this assumption, the Company has taken into account all available information about the future, which is at least, but is not limited to, 12 months from the balance sheet date. The Bank suffered recurring losses that eroded regulatory capital ratios during 2009, 2010, and 2011, resulting from the extraordinary effects of what may ultimately be the worst economic downturn since the Great Depression.

The effects of the uncertain economic environment are being felt across many industries, with financial services and residential real estate being particularly hard hit. The effects of the economic downturn were particularly severe during 2009, 2010, and 2011. The Bank, with a loan portfolio consisting of a concentration in commercial real estate loans, has seen a decline in the value of the collateral securing its portfolio, as well as rapid deterioration in its borrowers’ cash flow and ability to repay their outstanding loans to the Bank. As a result, the Bank’s level of nonperforming assets increased substantially during 2010 and 2011. For 2012, the Bank recorded a $5.3 million provision to increase the allowance for loan losses to a level which, in management’s best judgment, adequately reflected the risk inherent in the loan portfolio as of December 31, 2012. Nevertheless, given the current economic climate, management recognizes the possibility of further deterioration in the loan portfolio during 2013. For 2012, the Bank recorded net loan charge-offs of $5.2 million, or 1.32% of average loans, as compared to net loan charge-offs of $21.4 million, or 4.66% of average loans, for 2011. For the ~~three~~ six months ended ~~March~~June 3130, 2013, the Bank recorded net loan charge-offs of $~~843~~1.1 million,~~000,~~ or 0.8957% of average loans, as compared to net loan charge-offs of $12.34 million, or 1.3119% of average loans for the same period of 2012. Although the Company was profitable in 2012 and the first half of 2013, and asset quality has significantly improved during the past year, the Company’s low capital ratios have placed it in a weakened position to respond to adverse unforeseen events in the future.

The Company and the Bank operate in a highly regulated industry and must plan for the liquidity needs of each entity separately. A variety of sources of liquidity are available to the Bank to meet its short-term and long-term funding needs. Although a number of these sources have been limited following execution of the Consent Order with the FDIC and the Commissioner and the Written Agreement with the Federal Reserve Bank, management has prepared forecasts of these sources of funds and the Bank’s projected uses of funds during the next 12 months in an effort to ensure the sources available are sufficient to meet the Bank’s projected liquidity needs for at least the next 12 months, but if the Bank is unable to meet its liquidity needs, then the Bank may be placed into a federal conservatorship or receivership by the FDIC, with the FDIC appointed conservator or receiver.

The Company relies on dividends from the Bank as its primary source of liquidity. The Company is a legal entity separate and distinct from the Bank. Various legal limitations restrict the Bank from lending or otherwise supplying funds to the Company to meet its obligations, including paying dividends. In addition, the terms of the Consent Order described above further limit the Bank’s ability to pay dividends to the Company to satisfy its funding needs. Due to the regulatory restrictions which exist, that restrict cash payments between the Bank and the Company, the Company may be unable to realize its assets and discharge its liabilities in the normal course of business, in which ~~cash~~case the Company could be liquidated.

The Company will also need to raise substantial additional capital to increase its capital levels to meet the standards set forth by the Consent Order and Written Agreement. The Company’s ability to raise additional capital depends on conditions in the capital markets, economic conditions, and the Company’s financial performance and conditions, among other factors. Given the current state of the equity markets and the Company’s financial performance and condition, the Company’s ability to raise capital in the next 12 months and remain an independent institution is unknown. If additional equity cannot be secured, or can only be secured at an unexpectedly high cost, this could adversely affect the Company and could result in the Bank being placed in conservatorship or receivership by the FDIC or the Commissioner, and the Company could be liquidated.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

These matters raise substantial doubt about the Company’s ability to continue as a going concern. As a result of management’s assessment of the Company’s ability to continue as a going concern, the accompanying consolidated financial statements for the Company have been prepared on a going concern basis, which contemplates the realization of assets and the discharge of liabilities in the normal course of business for the foreseeable future, and does not include any adjustments to reflect the possible future effects on the recoverability or classification of assets.

Note 3 - Restrictions on Cash

The Company is required to maintain average reserve balances, computed by applying prescribed percentages to its various types of deposits, either at the Company or on deposit with the Federal Reserve Bank. At ~~March~~June 3130, 2013 and December 31, 2012, all required reserves were met by the Company’s vault cash.

At ~~March~~June 3130, 2013 and December 31, 2012, cash and cash equivalents totaling $941,000 were pledged as collateral against the Bank’s debit card and corporate credit card activity.

Note 4 - Investment Securities

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

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

Available-for-sale securities are reported at fair value and consist of bonds, notes, debentures, and certain equity securities not classified as trading securities or as held-to-maturity securities. The Company held no private-label mortgage-backed securities; the mortgage-backed securities owned by the Company have been issued by governmental entities, such as the Government National Mortgage Association (GNMA), the Federal National Mortgage Association (FNMA), and the Federal Home Loan Mortgage Corporation (FHLMC).

During the second quarter of 2013, due to uncertainty surrounding possible Federal Open Market Committee monetary policy changes and potential volatility in interest rates, the Company elected to transfer a portion of its available-for-sale securities, primarily longer-term, callable agencies to a held-to-maturity classification in order to lessen the potential adverse impact of rising interest rates on the portion of the investment portfolio classified as available-for-sale. Investment securities with an amortized cost of $146.2 million and fair value of $146.6 million were transferred, at fair value, from available-for-sale securities to held-to-maturity securities, as the Company intends to hold these securities to the maturity or call date.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Investments in available-for-sale securities are as follows:

(in thousands)
	March 31, 2013
	June 30, 2013
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
U.S. government agencies	$	5324,~~450~~036	$	~~360~~-	$	~~171~~716	$	5323,~~639~~320
Government-sponsored enterprises		~~150~~43,~~720~~688		~~302~~18		~~220~~1,348		~~150~~42,~~802~~358
Mortgage-backed securities		4439,~~253~~444		~~221~~59		~~170~~639		4438,~~304~~864
Total	$	~~248~~107,~~423~~168	$	~~883~~77	$	~~561~~2,703	$	~~248~~104,~~745~~542
	December 31, 2012
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
U.S. government agencies	$	38,736	$	465	$	132	$	39,069
Government-sponsored enterprises		167,318		696		101		167,913
Mortgage-backed securities		46,738		250		141		46,847
Total	$	252,792	$	1,411	$	374	$	253,829

	December 31, 2012
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
U.S. government agencies	$	38,736	$	465	$	132	$	39,069
Government-sponsored enterprises		167,318		696		101		167,913
Mortgage-backed securities		46,738		250		141		46,847
Total	$	252,792	$	1,411	$	374	$	253,829

At March 31, 2013 and December 31, 2012, investment securities with an amortized cost of $35.0 million and $35.5 million and a fair value of $35.1 million and $35.8 million, respectively, were pledged as collateral for lines or credit, securities sold under agreements to repurchase, and other banking purposes. Additionally, at March 31, 2013 and December 31, 2012, investment securities with an amortized cost of $7.2 million and fair value of $7.3 million were pledged to the Federal Reserve Bank against the Bank’s check clearing activity. During the three months ended March 31, 2013, proceeds from sales of investment securities were $9.0 million with gains recognized on the sales of $74,000 and losses recognized on the sales of $30,000. U.S. government-sponsored securities totaling $19.5 million were called during the first three months of 2013. During the three months ended March 31, 2012, proceeds from the sale of investment securities totaled $15.2 million. The gross realized gains on the sales of investment securities totaled $679,000 with no gross realized losses. During that period, U.S. government-sponsored securities totaling $17.0 million were called.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

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

Investments in held-to-maturity securities are as follows:

(in thousands)
	March 31, 2013
	June 30, 2013
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
U.S. government agencies	$	32,928	$	-	$	1,658	$	31,270
Government-sponsored enterprises		114,250		-		7,602		106,648
Mortgage-backed securities		8,315		-		546		7,769
Other debt securities		1,250		-		-		1,250
Total	$	156,743	$	-	$	9,806	$	146,937
	December 31, 2012
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
Other debt securities	$	1,250	$	-	$	-	$	1,250
Total	$	1,250	$	-	$	-	$	1,250

	December 31, 2012
			Gross		Gross
	Amortized		Unrealized		Unrealized		Fair
	Cost		Gains		Losses		Value
Other debt securities	$	1,250	$	-	$	-	$	1,250
Total	$	1,250	$	-	$	-	$	1,250

At June 30, 2013 and December 31, 2012, investment securities with an amortized cost of $33.5 million and $35.5 million and a fair value of $32.1 million and $35.8 million, respectively, were pledged as collateral for lines of credit, securities sold under agreements to repurchase, and other banking purposes. Additionally, at June 30, 2013, investment securities with an amortized cost of $7.5 million and fair value of $7.2 million were pledged to the Federal Reserve Bank against the Bank’s check clearing activity. During the six months ended June 30, 2013, proceeds from sales of investment securities were $15.9 million with gains recognized on the sales of $241,000 and losses recognized on the sales of $29,000. U.S. government-sponsored securities totaling $31.5 million were called during the first six months of 2013. During the six months ended June 30, 2012, proceeds from the sale of investment securities totaled $42.8 million with gains recognized on the sales of $1.3 million and no gross realized losses. During that period, U.S. government-sponsored securities totaling $61.8 million were called.

Declines in the fair value of individual held-to-maturity and available-for-sale securities below cost that are other than temporary are reflected as write-downs of the individual securities to fair value. Related write-downs are included in earnings as realized losses. During the ~~three~~six months ended ~~March~~June 3130, 2013 and 2012, the Company experienced no declines in the value of securities that were considered to be other than temporary in nature.

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

(in thousands)
	March 31, 2013
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
U. S. government agencies	$	19,378	$	94	$	2,117	$	77	$	21,495	$	171
Government-sponsored enterprises		56,477		220		-		-		56,477		220
Mortgage-backed securities		15,102		170		-		-		15,102		170
Total	$	90,957	$	484	$	2,117	$	77	$	93,074	$	561

	December 31, 2012
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
U. S. government agencies	$	7,494	$	49	$	2,160	$	83	$	9,654	$	132
Government-sponsored enterprises		25,807		101		-		-		25,807		101
Mortgage-backed securities		20,957		129		1,048		12		22,005		141
Total	$	54,258	$	279	$	3,208	$	95	$	57,466	$	374

As of March 31, 2013, three individual U.S. government agency securities (two U.S. Department of Agriculture securities and one Small Business Administration security) were in a continuous loss position for 12 months or more. As of December 31, 2012, the three above-mentioned U.S. government agency securities and one mortgage-backed security were in a continuous loss position for 12 months or more. The Company has the ability and intent to hold these four securities until such time as the values recover or the securities mature. The Company believes, based on their credit ratings, the deterioration in value is attributable to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered to be other than temporary.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

NoThe following tables detail the gross unrealized losses and related fair values in the Company’s available-for-sale and held-to-maturity investment securities ~~were~~portfolios. This ininformation anis ~~unrealized~~aggregated ~~loss~~by ~~position~~the atlength ~~March~~of ~~31,~~time ~~2013~~that orindividual ~~December~~securities ~~31,~~have ~~2012~~been in a continuous unrealized loss position.

Available-for-Sale Securities - Temporarily Impaired
(in thousands)
	June 30, 2013
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
U. S. government agencies	$	23,264	$	716	$	55	$	-	$	23,319	$	716
Government-sponsored enterprises		38,730		1,348		-		-		38,730		1,348
Mortgage-backed securities		34,687		639		-		-		34,687		639
Total	$	96,681	$	2,703	$	55	$	-	$	96,736	$	2,703


	December 31, 2012
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
U. S. government agencies	$	7,494	$	49	$	2,160	$	83	$	9,654	$	132
Government-sponsored enterprises		25,807		101		-		-		25,807		101
Mortgage-backed securities		20,957		129		1,048		12		22,005		141
Total	$	54,258	$	279	$	3,208	$	95	$	57,466	$	374

Held-to-Maturity Securities - Temporarily Impaired
(in thousands)
	June 30, 2013
	Less Than 12 Months				12 Months or More				Total
	Fair		Unrealized		Fair		Unrealized		Fair		Unrealized
	Value		Losses		Value		Losses		Value		Losses
U. S. government agencies	$	31,270	$	1,657	$	-	$	-	$	31,270	$	1,657
Government-sponsored enterprises		106,648		7,602		-		-		106,648		7,602
Mortgage-backed securities		7,769		547		-		-		7,769		547
Total	$	145,687	$	9,806	$	-	$	-	$	145,687	$	9,806

As of June 30, 2013, one available-for-sale U.S. government agency (Small Business Administration (SBA)) security was in a continuous loss position for 12 months or more. As of December 31, 2012, three individual available-for-sale U.S. government agency securities (two U.S. Department of Agriculture (USDA) securities and one SBA security) and one available-for-sale mortgage-backed security were in a continuous loss position for 12 months or more. During the second quarter of 2013, the Company received full payment on the two USDA securities that were in a continuous loss position at December 31, 2012. The Company has the ability and intent to hold the remaining securities until such time as the values recover or the securities mature. The Company believes, based on their credit ratings, the deterioration in value is attributable to changes in market interest rates and not in the credit quality of the issuer and therefore, these losses are not considered to be other than temporary.

No held-to-maturity securities were in an unrealized loss position for 12 months or more at June 30, 2013 or December 31, 2012.

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

Available-for-Sale Investment Securities
(in thousands)
	March 31, 2013				December 31, 2012
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
U. S. government agencies
Due within one year	$	-	$	-	$	-	$	-
Due after one but within five years		64		64		76		76
Due after five but within ten years		3,120		3,100		3,149		3,139
Due after ten years		50,266		50,475		35,511		35,854
Government-sponsored enterprises
Due within one year		-		-		-		-
Due after one but within five years		-		-		-		-
Due after five but within ten years		52,786		52,915		59,390		59,721
Due after ten years		97,934		97,887		107,928		108,192
Mortgage-backed securities		44,253		44,304		46,738		46,847
Total	$	248,423	$	248,745	$	252,792	$	253,829

Held-to-Maturity Investment Securities
(in thousands)
	March 31, 2013				December 31, 2012
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
Other debt securities
Due within one year	$	-	$	-	$	-	$	-
Due after one but within five years		-		-		-		-
Due after five but within ten years		1,250		1,250		1,250		1,250
Due after ten years		-		-		-		-
Total	$	1,250	$	1,250	$	1,250	$	1,250

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Available-for-Sale Investment Securities
(in thousands)
	June 30, 2013				December 31, 2012
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
U. S. government agencies
Due within one year	$	-	$	-	$	-	$	-
Due after one but within five years		55		55		76		76
Due after five but within ten years		3,115		3,018		3,149		3,139
Due after ten years		20,866		20,247		35,511		35,854
Government-sponsored enterprises
Due within one year		-		-		-		-
Due after one but within five years		-		-		-		-
Due after five but within ten years		28,834		27,888		59,390		59,721
Due after ten years		14,854		14,470		107,928		108,192
Mortgage-backed securities		39,444		38,864		46,738		46,847
Total	$	107,168	$	104,542	$	252,792	$	253,829

Held-to-Maturity Investment Securities
(in thousands)
	June 30, 2013				December 31, 2012
	Amortized		Fair		Amortized		Fair
	Cost		Value		Cost		Value
U. S. government agencies
Due within one year	$	-	$	-	$	-	$	-
Due after one but within five years		-		-		-		-
Due after five but within ten years		-		-		-		-
Due after ten years		32,928		31,270		-		-
Government-sponsored enterprises
Due within one year		-		-		-		-
Due after one but within five years		-		-		-		-
Due after five but within ten years		36,041		34,025		-		-
Due after ten years		78,209		72,623		-		-
Other debt securities
Due within one year		-		-		-		-
Due after one but within five years		1,250		1,250		-		-
Due after five but within ten years		-		-		1,250		1,250
Due after ten years		-		-		-		-
Mortgage-backed securities		8,315		7,769		-		-
Total	$	156,743	$	146,937	$	1,250	$	1,250

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Note 5 - Loans

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

Loans
(in thousands)
	March 31 2013			December 31 2012
	June 30 2013			December 31 2012
Real estate:
Construction and development	$	6156,~~715~~843		$	68,954
1-4 family residential		~~127~~124,~~417~~591			126,468
Multifamily		6,~~903~~853			6,292
Nonfarm, nonresidential		~~141~~137,~~139~~356			147,894
Total real estate		~~337~~325,~~174~~643			349,608
Commercial and industrial		3435,~~910~~184			35,182
Consumer		2,~~550~~528			2,867
		374,634			387,657
		363,355			387,657
Allowance for loan losses		(10,~~787~~564	)		(10,690	)
Total	$	~~363~~352,~~847~~791		$	376,967

The Company sells the guaranteed portion of selected USDA and SBA loans in the secondary market, yet we retain the rights to service these loans. At the time the loan is sold, we recognize a loan servicing asset and thereafter, we recognize monthly service fee income, net of servicing asset amortization. There were no USDA or SBA loan sales during the first ~~three~~six months of 2013. During the first ~~three~~six months of 2012, the guaranteed portion of USDA and SBA loans sold totaled $5.46 million with gains of $~~557~~577,000 recognized on the sales. Loans serviced for others totaled $22.53 million at ~~March~~June 3130, 2013, ~~and~~compared to $22.8 million at December 31, 2012, and the associated loan servicing asset was $~~247~~214,000 at ~~March~~June 3130, 2013, compared to $280,000 at December 31, 2012. Servicing income, net of amortization, totaled $24,000 and $715,000 for the ~~three~~six months ended ~~March~~June 3130, 2013 and 2012, respectively.

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

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

●

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

●

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

●

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

1516

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

●

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

●

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

●

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

●

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

●

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

●

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

1617

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

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

Loan Analysis by Credit Quality Indicators
(in thousands)
	March 31, 2013
	June 30, 2013
	Construction & Land Development		1-4 Family Residential		Multifamily		Nonfarm Nonresidential		Commercial & Industrial		Consumer		Total
Extremely low risk - 1	$	-	$	-	$	-	$	-	$	3,~~518~~573	$	1-	$	3,~~519~~573
Minimal risk - 2		-		-		-		~~236~~231		~~117~~105		-		~~353~~336
Moderate risk - 3		~~833~~813		1,~~395~~333		2,~~580~~560		9,~~908~~736		75,~~050~~397		1514		2119,~~781~~853
Satisfactory risk - 4		63,~~336~~686		10,~~978~~662		2,~~711~~578		4746,~~775~~725		15,~~073~~625		~~269~~232		8379,~~142~~508
Acceptable risk - 5		20,~~664~~182		13,~~179~~709		1,~~612~~715		5048,~~331~~239		78,~~651~~592		68		9392,~~443~~445
Special mention - 6		1315,~~371~~968		4,~~476~~301		-		2021,~~166~~499		~~355~~622		-1		3842,~~368~~391
Substandard - 7		127,~~299~~937		43,~~287~~283		-		1210,~~723~~926		1,~~146~~270		37		3023,~~458~~423
Doubtful - 8		-		4140		-		-		-		-		4140
Consumer, not graded		8,~~212~~257		9391,~~061~~263		-		-		-		2,~~256~~266		~~103~~101,~~529~~786
Total	$	6156,~~715~~843	$	~~127~~124,~~417~~591	$	6,~~903~~853	$	~~141~~137,~~139~~356	$	3435,~~910~~184	$	2,~~550~~528	$	~~374~~363,~~634~~355
	December 31, 2012
	Construction & Land Development		1-4 Family Residential		Multifamily		Nonfarm Nonresidential		Commercial & Industrial		Consumer		Total
Extremely low risk - 1	$	-	$	-	$	-	$	-	$	3,552	$	-	$	3,552
Minimal risk - 2		-		-		-		240		130		-		370
Moderate risk - 3		596		1,729		2,600		11,948		4,246		17		21,136
Satisfactory risk - 4		6,545		11,122		2,049		49,371		16,358		292		85,737
Acceptable risk - 5		22,286		10,290		1,643		49,051		9,297		4		92,571
Special mention - 6		14,824		6,924		-		20,980		648		-		43,376
Substandard - 7		15,711		5,133		-		16,304		951		12		38,111
Doubtful - 8		-		42		-		-		-		-		42
Consumer, not graded		8,992		91,228		-		-		-		2,542		102,762
Total	$	68,954	$	126,468	$	6,292	$	147,894	$	35,182	$	2,867	$	387,657

	December 31, 2012
	Construction & Land Development		1-4 Family Residential		Multifamily		Nonfarm Nonresidential		Commercial & Industrial		Consumer		Total
Extremely low risk - 1	$	-	$	-	$	-	$	-	$	3,552	$	-	$	3,552
Minimal risk - 2		-		-		-		240		130		-		370
Moderate risk - 3		596		1,729		2,600		11,948		4,246		17		21,136
Satisfactory risk - 4		6,545		11,122		2,049		49,371		16,358		292		85,737
Acceptable risk - 5		22,286		10,290		1,643		49,051		9,297		4		92,571
Special mention - 6		14,824		6,924		-		20,980		648		-		43,376
Substandard - 7		15,711		5,133		-		16,304		951		12		38,111
Doubtful - 8		-		42		-		-		-		-		42
Consumer, not graded		8,992		91,228		-		-		-		2,542		102,762
Total	$	68,954	$	126,468	$	6,292	$	147,894	$	35,182	$	2,867	$	387,657

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

The following is a summary loan aging analysis.

Loan Aging Analysis
(in thousands)
	March 31, 2013
June 30, 2013
									Total
	Past Due and Accruing								Past Due &
	30-59 days		60-89 days		90 or more days		Nonaccrual		Nonaccrual		Current		Total Loans
Construction and
Construction and development	$	309	$	-	$	-	$	6,472	$	6,781	$	50,062	$	56,843
development	$	770	$	140	$	-	$	5,434	$	6,344	$	55,371	$	61,715
1-4 family residential		1,170		50		-		6,452		7,672		116,919		124,591
1-4 family residential		461		106		-		6,940		7,507		119,910		127,417
Multifamily		-		-		-		-		-		6,853		6,853
Multifamily		-		-		-		-		-		6,903		6,903
Nonfarm, nonresidential		577		142		-		8,615		9,334		128,022		137,356
Nonfarm, nonresidential		482		187		-		8,468		9,137		132,002		141,139
Total real estate loans		2,056		192		-		21,539		23,787		301,856		325,643
Total real estate loans		1,713		433		-		20,842		22,988		314,186		337,174
Commercial and industrial		67		-		-		579		646		34,538		35,184
Commercial and industrial		226		191		-		454		871		34,039		34,910
Consumer		5		-		-		-		5		2,523		2,528
Consumer		30		3		-		-		33		2,517		2,550
Total loans	$	2,128	$	192	$	-	$	22,118	$	24,438	$	338,917	$	363,355
Total loans	$	1,969	$	627	$	-	$	21,296	$	23,892	$	350,742	$	374,634


	December 31, 2012
										Total
		Past Due and Accruing								Past Due &
		30-59 days		60-89 days		90 or more days		Nonaccrual		Nonaccrual		Current		Total Loans
Construction and development		$	173	$	-	$	-	$	10,012	$	10,185	$	58,769	$	68,954
1-4 family residential			713		102		-		6,774		7,589		118,879		126,468
Multifamily			-		-		-		-		-		6,292		6,292
Nonfarm, nonresidential			469		-		-		11,523		11,992		135,902		147,894
Total real estate loans			1,355		102		-		28,309		29,766		319,842		349,608
Commercial and industrial			249		-		-		246		495		34,687		35,182
Consumer			-		2		-		10		12		2,855		2,867
Total loans		$	1,604	$	104	$	-	$	28,565	$	30,273	$	357,384	$	387,657

At ~~March~~June 3130, 2013, the Company had $2122.31 million in nonaccrual loans, compared to $28.6 million at December 31, 2012. The year-to-date foregone interest associated with these loans, which averaged $2123.60 million for the ~~three~~six months ended ~~March~~June 3130, 2013, and $3027.17 million for the comparable period in 2012, was $~~321~~660,000 and $~~508~~994,000 for the respective periods.

1819

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

The following table summarizes information relative to impaired loans.

Impaired Loan Schedule

(in thousands)

March 31, 2013

June 30, 2013

Construction & Land Development

1-4 Family Residential

Nonfarm Nonresidential

Commercial & Industrial

Construction

Consumer

Total

& Land Development

1-4 Family Residential

Nonfarm Nonresidential

Commercial & Industrial

Consumer

Total

With no related allowance recorded

Recorded investment

6,~~658~~158

76,~~562~~198

1110,~~152~~464

2,~~970~~745

2825,~~342~~565

Unpaid principal balance

87,~~955~~692

87,~~648~~224

1110,~~590~~939

32,~~080~~899

3228,~~273~~754

Related allowance

Average recorded investment

96,~~551~~271

76,~~598~~276

11,~~262~~069

3,~~088~~193

3126,~~499~~809

Interest income recognized

65115

60108

~~133~~260

4086

~~298~~569

With an allowance recorded

Recorded investment

62,~~080~~250

1,~~815~~645

65,~~740~~628

1,~~480~~781

1611,~~162~~351

Unpaid principal balance

62,~~208~~378

1,~~880~~741

65,~~842~~762

1,~~480~~781

1611,~~457~~709

Related allowance

~~2,622~~870

~~256~~199

~~461~~303

~~241~~511

31,~~582~~884

Average recorded investment

62,~~088~~253

1,~~827~~670

6,~~768~~208

1,~~497~~818

4847

1611,~~228~~996

Interest income recognized

6327

1653

98179

442

-1

~~181~~302

Total

Recorded investment

128,~~738~~408

97,~~377~~843

1716,~~892~~092

4,~~450~~526

4436,~~504~~916

Unpaid principal balance

1510,~~163~~070

108,~~528~~965

1816,~~432~~701

4,~~560~~680

4840,~~730~~463

Related allowance

~~2,622~~870

~~256~~199

~~461~~303

~~241~~511

31,~~582~~884

Average recorded investment

158,~~639~~524

97,~~425~~946

1817,~~030~~277

45,~~585~~011

4847

4738,~~727~~805

Interest income recognized

~~128~~142

76161

~~231~~439

44128

-1

~~479~~871


	December 31, 2012
		Construction
		& Land Development		1-4 Family Residential		Nonfarm Nonresidential		Commercial & Industrial		Consumer		Total
With no related allowance recorded
Recorded investment		$	11,010	$	7,008	$	9,979	$	3,372	$	-	$	31,369
Unpaid principal balance			14,532		8,173		10,303		3,481		-		36,489
Related allowance			-		-		-		-		-		-
Average recorded investment			12,147		7,273		10,134		4,108		-		33,662
Interest income recognized			410		301		456		270		-		1,437
With an allowance recorded
Recorded investment		$	4,666	$	1,300	$	10,497	$	1,086	$	48	$	17,597
Unpaid principal balance			4,793		1,362		11,130		1,086		48		18,419
Related allowance			1,834		171		1,142		146		2		3,295
Average recorded investment			4,824		1,371		10,788		1,156		49		18,188
Interest income recognized			262		64		430		71		2		829
Total
Recorded investment		$	15,676	$	8,308	$	20,476	$	4,458	$	48	$	48,966
Unpaid principal balance			19,325		9,535		21,433		4,567		48		54,908
Related allowance			1,834		171		1,142		146		2		3,295
Average recorded investment			16,971		8,644		20,922		5,264		49		51,850
Interest income recognized			672		365		886		341		2		2,266

Included in impaired loans, are troubled debt restructurings (TDRs), which totaled $19.4 million at ~~March~~June 3130, 2013, compared to $21.8 million at December 31, 2012. As of ~~March~~June 3130, 2013, $5.07 million of TDRs were accruing interest, compared to $4.8 million at December 31, 2012. The allowance for loan losses associated with these loans, on the basis of a current evaluation of loss was $~~481~~504,000 at ~~March~~June 3130, 2013 and $220,000 at December 31, 2012~~, respectively~~.

1920

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Troubled Debt Restructurings (TDRs)

The following table summarizes the pre-modification and post-modification balance of TDRs at the dates indicated.

(in thousands, except contracts)
	At March 31, 2013						At December 31, 2012
	At June 30, 2013						At December 31, 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
Construction & land development		912	$	65,~~921~~748	$	5,~~276~~155		9	$	9,471	$	6,580
1-4 family residential		2322		86,~~015~~733		65,~~606~~490		23		8,024		6,583
Nonfarm, nonresidential		1415		710,~~852~~417		78,~~460~~540		13		9,089		8,608
Total real estate loans		4649		22,~~788~~898		19,~~342~~185		45		26,584		21,771
Commercial and industrial		35		~~142~~641		17212		3		142		20
Consumer		1		51		4847		1		51		48
Total loans		5055	$	2223,~~981~~590	$	19,~~407~~444		49	$	26,777	$	21,839

The following table summarizes, by class, loans that were modified resulting in TDRs during the periods indicated.

(in thousands, except contracts)
	For the Three Months Ended March 31
	For the Three Months Ended June 30
	2013						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
Construction & land development		14	$	51366	$	51351		31	$	12,~~731~~600	$	12,~~427~~600
1-4 family residential		14		~~216~~308		~~174~~308		2		~~371~~1,098		~~370~~1,098
Nonfarm, nonresidential		32		2,~~438~~587		21,~~355~~671		-1		-975		-967
Total real estate loans		510		23,~~705~~261		2,~~580~~330		54		24,~~102~~673		14,~~797~~665
Commercial and industrial		-		-		-		-		-		-
Consumer		-		-		-		-		-		-
Total loans		510	$	23,~~705~~261	$	2,~~580~~330		54	$	24,~~102~~673	$	14,~~797~~665

The following table summarizes, by type of concession, loans that were modified resulting in TDRs during the periods indicated.

Troubled Debt Restructurings Concession Type
(in thousands, except contracts)
		For the Three Months Ended March 31
	For the Three Months Ended June 30
		2013				2012
		Number of Contracts		Recorded Investment		Number of Contracts		Recorded Investment
Rate concessions			-	$	-		-	$	-
Term concessions			1-		51-		3-		~~1,566~~-
Rate and term concessions			13		~~252~~1,777		-2		-1,098
Total rate or term concessions			23		~~303~~1,777		32		1,~~566~~098
Foreclosures			37		~~2,277~~553		2		~~231~~3,567
Total concessions			510	$	2,~~580~~330		54	$	14,~~797~~665

2021

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

The following table summarizes TDRs removed from this classification during the periods indicated.

Troubled Debt Restructurings Removed During the Period
(in thousands, except contracts)
		For the Three Months Ended March 31
	For the Three Months Ended June 30
	2013	~~2013~~				2012
		Number of Contracts		Recorded Investment		Number of Contracts		Recorded Investment
Construction & land development			1	$	~~1,144~~400		42	$	~~1,100~~162
1-4 family residential			13		85491		15		231,184
Nonfarm, nonresidential			21		~~3,467~~23		21		~~888~~269
Total real estate loans			45		~~4,696~~914		78		21,~~011~~615
Commercial and industrial			-		-		3-		~~2,501~~-
Total loans			45	$	~~4,696~~914		108	$	41,~~512~~615

(in thousands, except contracts)
	For the Three Months Ended March 31
	2013				2012
	Number of Contracts		Recorded Investment		Number of Contracts		Recorded Investment
Construction & land development		-	$	-		5	$	486
1-4 family residential		-		-		-		-
Nonfarm, nonresidential		-		-		-		-
Total real estate loans		-		-		5		486
Commercial and industrial		-		-		-		-
Total loans		-	$	-		5	$	486

The following table summarizes, by class, loans modified resulting in TDRs for which there was a payment default during the periods indicated.

Troubled Debt Restructurings that Subsequently Defaulted
(in thousands, except contracts)
	For the Three Months Ended June 30
		2013				2012
		Number of Contracts		Recorded Investment		Number of Contracts		Recorded Investment

Construction & land development			-	$	-		-	$	-
1-4 family residential			1		85		2		209
Nonfarm, nonresidential			-		-		-		-
Total real estate loans			1		85		2		209
Commercial and industrial			-		-		-		-
Total loans			1	$	85		2	$	209

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

The following table provides information about the Bank’s nonperforming assets at the dates indicated.

(dollars in thousands)
	March 31 2013			December 31 2012
	June 30 2013			December 31 2012
Nonaccrual loans	$	2122,~~296~~118		$	28,565
Loans past due 90 or more days and still accruing interest		-			-
Total nonperforming loans		2122,~~296~~118			28,565
Foreclosed real estate		1513,~~733~~585			9,821
Repossessed assets		-			-
Total nonperforming assets	$	35,703		$	38,386
Total nonperforming assets	$	37,029		$	38,386
Allowance for loan losses	$	10,564		$	10,690
Allowance for loan losses	$	10,787		$	10,690
Nonperforming loans to period-end loans, excluding loans held for sale		6.09	%		7.37	%
Nonperforming loans to period-end loans, excluding loans held for sale		5.68	%		7.37	%
Allowance for loan losses to period-end loans, excluding loans held for sale		2.91	%		2.76	%
Allowance for loan losses to period-end loans, excluding loans held for sale		2.88	%		2.76	%
Nonperforming assets as a percentage of:
Loans and foreclosed assets		9.4947	%		9.66	%
Total assets		5.3116	%		5.40	%
Ratio of allowance for loan losses to nonperforming loans		5047.78	%		37.4	%

2223

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Note 6 - Allowance for Loan Losses

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

(dollars in thousands)
	Three Months Ended March 31
	Three Months Ended June 30						Six Months Ended June 30
	2013			2012			2013			2012
Balance at beginning of the period	$	10,~~690~~787		$	10,~~650~~414		$	10,690		$	10,650
Provision for loan losses		~~940~~-			~~1,105~~935			940			2,040
Charge-offs
Construction and development		66-			~~477~~278			66			755
1-4 family residential		1136			~~844~~392			137			1,236
Nonfarm, nonresidential		~~853~~103			~~112~~50			956			162
Total real estate		~~920~~239			~~1,433~~720			1,159			2,153
Commercial		-40			47455			40			502
Consumer		1112			28-			23			28
Total charge-offs		~~931~~291			1,~~508~~175			1,222			2,683
Recoveries
Construction and development		5929			9736			88			133
1-4 family residential		-			234			-			27
Nonfarm, nonresidential		12			-			3			-
Total real estate		6031			~~120~~40			91			160
Commercial		2816			4579			44			124
Consumer		-21			2			21			4
Total recoveries		8868			~~167~~121			156			288
Net charge-offs		~~843~~223			1,~~341~~054			1,066			2,395
Balance at end of period	$	10,~~787~~564		$	10,~~414~~295		$	10,564		$	10,295
Average loans, excluding loans held for sale	$	~~383~~368,~~007~~798		$	~~412~~397,~~275~~889		$	375,863		$	405,082
Period end loans, excluding loans held for sale	$	~~374~~363,~~634~~355		$	~~400~~393,~~534~~617		$	363,355		$	393,617
Net charge-offs to average loans, excluding loans held for sale (1)		0.8924	%		1.3106	%		0.57	%		1.19	%
Allowance for loan losses to period end loans, excluding loans held for sale		2.8891	%		2.6062	%		2.91	%		2.62	%
(1) Annualized

2324

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

The following tables outline the changes in the allowance for loan losses by collateral type, the allowances for loans individually and collectively evaluated for impairment, and the amount of loans individually and collectively evaluated for impairment at ~~March~~June 3130, 2013 and December 31, 2012.

Allowance for Loan Losses and Recorded Investment in Loans Receivable
(in thousands)
	As of and for the Three Months Ended March 31, 2013
	As of and for the Six Months Ended June 30, 2013
	Construction & Land Development			1-4 Family Residential			Multifamily			Nonfarm Nonresidential			Commercial & Industrial			Consumer			Unallocated			Total
Allowance for Loan Losses
Beginning balance	$	5,503		$	2,142		$	45		$	1,976		$	817		$	107		$	100		$	10,690
Provision for loan losses		~~582~~(1,080	)		64(56	)		54			~~291~~318			77304			4(2	)		~~(83~~1,452	)		940
Charge-offs		(66	)		(1137	)		-			(~~853~~956	)		-(40	)		(1123	)		-			(~~931~~1,222	)
Recoveries		5988			-			-			13			2844			-21			-			88156
Ending balance	$	64,~~078~~445		$	21,~~205~~949		$	5049		$	1,~~415~~341		$	~~922~~1,125		$	~~100~~103		$	171,552		$	10,~~787~~564
Ending allowance balance for
Ending allowance balance for loans individually evaluated for impairment	$	870		$	199		$	-		$	303		$	511		$	1		$	-		$	1,884
loans individually evaluated
Ending allowance balance for loans collectively evaluated for impairment	$	3,575		$	1,750		$	49		$	1,038		$	614		$	102		$	1,552		$	8,680
for impairment	$	2,622		$	256		$	-		$	461		$	241		$	2		$	-		$	3,582
Ending allowance balance for
loans collectively evaluated
for impairment	$	3,456		$	1,949		$	50		$	954		$	681		$	98		$	17		$	7,205
Loans Receivable
Total period-end balance	$	6156,~~715~~843		$	~~127~~124,~~417~~591		$	6,~~903~~853		$	~~141~~137,~~139~~356		$	3435,~~910~~184		$	2,~~550~~528		$	-		$	~~374~~363,~~634~~355
Balance of loans individually
Balance of loans individually evaluated for impairment	$	8,408		$	7,843		$	-		$	16,092		$	4,526		$	47		$	-		$	36,916
evaluated for impairment	$	12,738		$	9,377		$	-		$	17,892		$	4,450		$	47		$	-		$	44,504
Balance of loans collectively evaluated for impairment	$	48,435		$	116,748		$	6,853		$	121,264		$	30,658		$	2,481		$	-		$	326,439
Balance of loans collectively
	As of and for the Year Ended December 31, 2012
evaluated for impairment	$	48,977		$	118,040		$	6,903		$	123,247		$	30,460		$	2,503		$	-		$	330,130
	Construction & Land Development			1-4 Family Residential			Multifamily			Nonfarm Nonresidential			Commercial & Industrial			Consumer			Unallocated			Total
Allowance for Loan Losses
Beginning balance	$	6,463		$	1,553		$	52		$	1,277		$	1,182		$	92		$	31		$	10,650
Provision for loan losses		1,096			2,553			(7	)		1,503			(14	)		76			69			5,276
Charge-offs		(2,272	)		(2,059	)		-			(830	)		(597	)		(69	)		-			(5,827	)
Recoveries		216			95			-			26			246			8			-			591
Ending balance	$	5,503		$	2,142		$	45		$	1,976		$	817		$	107		$	100		$	10,690
Ending allowance balance for loans individually evaluated for impairment	$	1,834		$	171		$	-		$	1,142		$	146		$	2		$	-		$	3,295
Ending allowance balance for loans collectively evaluated for impairment	$	3,669		$	1,971		$	45		$	834		$	671		$	105		$	100		$	7,395
Loans Receivable
Total period-end balance	$	68,954		$	126,468		$	6,292		$	147,894		$	35,182		$	2,867		$	-		$	387,657
Balance of loans individually evaluated for impairment	$	15,676		$	8,308		$	-		$	20,476		$	4,458		$	48		$	-		$	48,966
Balance of loans collectively evaluated for impairment	$	53,278		$	118,160		$	6,292		$	127,418		$	30,724		$	2,819		$	-		$	338,691

	As of and for the Year Ended December 31, 2012
	Construction & Land Development			1-4 Family Residential			Multifamily			Nonfarm Nonresidential			Commercial & Industrial			Consumer			Unallocated		Total
Allowance for Loan Losses
Beginning balance	$	6,463		$	1,553		$	52		$	1,277		$	1,182		$	92		$	31	$	10,650
Provision for loan losses		1,096			2,553			(7	)		1,503			(14	)		76			69		5,276
Charge-offs		(2,272	)		(2,059	)		-			(830	)		(597	)		(69	)		-		(5,827	)
Recoveries		216			95			-			26			246			8			-		591
Ending balance	$	5,503		$	2,142		$	45		$	1,976		$	817		$	107		$	100	$	10,690
Ending allowance balance for
loans individually evaluated
for impairment	$	1,834		$	171		$	-		$	1,142		$	146		$	2		$	-	$	3,295
Ending allowance balance for
loans collectively evaluated
for impairment	$	3,669		$	1,971		$	45		$	834		$	671		$	105		$	100	$	7,395
Loans Receivable
Total period-end balance	$	68,954		$	126,468		$	6,292		$	147,894		$	35,182		$	2,867		$	-	$	387,657
Balance of loans individually
evaluated for impairment	$	15,676		$	8,308		$	-		$	20,476		$	4,458		$	48		$	-	$	48,966
Balance of loans collectively
evaluated for impairment	$	53,278		$	118,160		$	6,292		$	127,418		$	30,724		$	2,819		$	-	$	338,691

24Back to "Table of Contents"

1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Note 7 - Foreclosed Real Estate and Repossessed Assets

The following table shows the composition of foreclosed real estate.

(in thousands)
	March 31 2013		December 31 2012
	June 30		December 31
Construction and development	$	10,474	$	7,164
	2013		2012
1-4 family residential		448		433
Construction and development	$	8,736	$	7,164
Nonfarm, nonresidential		4,811		2,224
1-4 family residential		119		433
Balance at end of period	$	15,733	$	9,821
Nonfarm, nonresidential		4,730		2,224
Balance at end of period	$	13,585	$	9,821

The following table summarizes the activity in foreclosed real estate for the ~~three~~six months ended ~~March~~June 3130, 2013 and the year ended December 31, 2012.

(in thousands)
	March 31 2013			December 31 2012
	June 30 2013			December 31 2012
Balance at beginning of year	$	9,821		$	19,333
Additions from loans		67,~~990~~072			4,773
Sales		(779	)		(13,302	)
Improvements		98			-
Writedowns		(299	)		(983	)
Sales		(2,904	)		(13,302	)
Balance at end of period	$	15,733		$	9,821
Writedowns		(502	)		(983	)
Balance at end of period	$	13,585		$	9,821

The Company had no repossessed assets at ~~March~~June 3130, 2013 or December 31, 2012.

Note 8 - Restricted Equity Securities

The Bank, as a member institution is required to own stock in the Federal Home Loan Bank of Atlanta (FHLB). No ready market exists for this stock and it has no quoted market value; however, redemption of this stock has historically been at par. At ~~March~~June 3130, 2013 and December 31, 2012, the Bank owned $853,000 and $1.1 million, respectively, in FHLB stock. Investments in FHLB stock, in excess of the minimum amount required by the FHLB, are redeemed at the discretion of the FHLB. During the first ~~three~~six months of 2013, $~~197~~198,000 of excess FHLB stock was redeemed, which represented all stock in excess of the minimum amount required at that date. Also included in restricted equity securities at ~~March~~June 3130, 2013 and December 31, 2012, was an investment in the Senior Housing Crime Prevention Fund of $500,000, an investment in Pacific Coast Bankers Bank stock of $102,000, and an investment in Capital South Partners, LLC (a Small Business Investment Corporation), ofwhich totaled $1.47 million at June 30, 2013, compared to $1.4 million at December 31, 2012. As of ~~March~~June 3130, 2013, unfunded commitments on the Capital South Partners, LLC investment totaled $~~350~~100,000.

2526

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Note 9 - Property and Equipment

The following table highlights the components of property and equipment and accumulated depreciation at the dates indicated.

(in thousands)
	March 31			December 31
	June 30			December 31
	2013			2012
Premises:
Land and land improvements	$	~~860~~867		$	832
Buildings		1,602			1,602
Leasehold improvements		2,~~146~~142			2,143
Furniture and fixtures		3,~~769~~734			3,730
Computer and telecom equipment and software		1,~~411~~379			1,390
Other		26			26
Property and equipment, total		9,~~814~~750			9,723
Less accumulated depreciation		(5,~~504~~598	)		(5,313	)
Property and equipment, net	$	4,~~310~~152		$	4,410

Depreciation expense totaled $~~202~~400,000 and $~~225~~446,000 for the ~~three~~six month periods ended ~~March~~June 3130, 2013 and 2012, respectively.

Note 10 - Time Deposits

Time deposits totaled $~~285~~286.81 million at ~~March~~June 3130, 2013, compared to $296.3 million at December 31, 2012. Of that total, time deposits in denominations of $100,000 or more were $~~145~~147.49 million and $151.6 million at ~~March~~June 3130, 2013 and December 31, 2012, respectively. Interest expense on deposits of $100,000 or more aggregated $~~394~~775,000 and $~~567,000~~1.1 million for the ~~three~~six months ended ~~March~~June 3130, 2013 and 2012, respectively.

Time deposits maturing subsequent to ~~March~~June 3130, 2013, are as follows:

(in thousands)
Maturing in	Amount
2013	$	~~206~~166,~~364~~852
2014		4277,~~243~~900
2015		15,~~021~~336
2016		1316,~~941~~075
2017		78,~~415~~177
2018		~~809~~1,733
	$	~~285~~286,~~793~~073

26At June 30, 2013 and December 31, 2012, the Company had $348,000 and $937,000, respectively, in brokered certificates of deposit. Under the terms of the Consent Order, the Bank is prohibited from soliciting and accepting brokered certificates of deposit (including the renewal of existing brokered certificates of deposit), unless it first receives an appropriate waiver from the FDIC. Accordingly, as brokered certificates of deposit mature, the certificates are not being rolled over into other certificates.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Note 11 - Borrowings

At ~~March~~June 3130, 2013 and December 31, 2012, the Company’s borrowings consisted of securities sold under agreements to repurchase, and are summarized below:

(dollars in thousands)
	March 31, 2013					December 31, 2012
	June 30, 2013					December 31, 2012
			Weighted					Weighted
			Average					Average
	Amount		Rate			Amount		Rate
Securities sold under agreements to repurchase	$	~~408~~668		0.1922	%	$	436		0.21	%
Total	$	~~408~~668		0.1922	%	$	436		0.21	%

Note 12 - Income Taxes

Deferred tax assets represent the future tax benefit of deductible differences and, if it is more likely than not that a tax asset will not be realized, a valuation allowance is required to reduce the recorded deferred tax assets to net realizable value. A valuation allowance is recognized against deferred tax assets when, based on the consideration of all available evidence using a more likely that not criteria, it is determined that some portion of these tax benefits may not be realized. This assessment requires consideration of all sources of taxable income available to realize the deferred tax asset including taxable income in prior carryback years, future reversals of existing temporary differences, tax planning strategies and future taxable income exclusive of reversing temporary differences and carryforwards. The predictability that future taxable income, exclusive of reversing temporary differences, will occur is the most subjective of these four sources. The presence of cumulative losses in recent years is considered significant negative evidence, making it difficult for a company to rely on future taxable income, exclusive of reversing temporary differences and carryforwards, as a reliable source of taxable income to realize a deferred tax asset. Judgment is a critical element in making this assessment.

During 2010, the Company reached a three-year cumulative pre-tax loss position and at that time, recorded a partial valuation allowance in the amount of $4.0 million. During 2011, based upon additional losses and the weighting ascribed to this evidence, the Company determined a full valuation allowance was necessary under the accounting standards and established an allowance totaling $18.0 million to reflect its estimate of net realizable value as of the financial statement date. As of ~~March~~June 3130, 2013 and December 31, 2012, the valuation allowance totaled $17.57 million and $17.6 million, respectively. In addition, the Company maintains a full valuation allowance against the deferred tax asset related to its net unrealized loss position on the available-for-sale securities portfolio. This valuation allowance totaled $1.2 million at June 30, 2013. There was no similar valuation allowance at December 31, 2012, as the available-for-sale securities portfolio was in an unrealized gain position.

Pursuant to accounting pronouncement ASC 740-10, the Company has reviewed its income tax positions and specifically considered the recognition and measurement requirements of the benefits recorded in its financial statements for tax positions taken or expected to be taken in its tax returns. Based on its evaluation of these tax positions for its open tax years, the Company has not recorded any tax liability or uncertain tax positions as of ~~March~~June 3130, 2013 and December 31, 2012. Federal tax returns have been examined by the Internal Revenue Service through 2008.

Note 13 - Net Income per Common Share

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

For the ~~three~~six months ended ~~March~~June 3130, 2013, basic weighted-average shares and diluted weighted-average shares outstanding were 5,204,~~385~~109, equating to basic earnings per share and diluted earnings per share of $0.0432 per share for the period. For the ~~three~~six months ended ~~March~~June 3130, 2012, basic weighted-average shares and diluted weighted-average shares outstanding totaled 5,~~183~~191,~~117~~753, amounting to basic earnings per share and diluted earnings per share of $0.0608 per share for the period.

27Additionally, 688,935 shares attributable to outstanding stock options and a warrant to purchase 276,815 shares of common stock were excluded from the calculation of net income per share for the six months ended June 30, 2013, because their inclusion was not deemed to be dilutive as their exercise price was greater than the average market price of the common shares. For the six months ended June 30, 2012, 693,038 options and a warrant to purchase 276,815 shares of common stock were excluded from the net income per share calculations for the same reason.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Additionally, 690,108 shares attributable to outstanding stock options and a warrant to purchase 276,815 shares of common stock were excluded from the calculation of net income per share for the three months ended March 31, 2013, because their inclusion was not deemed to be dilutive as their exercise price was greater than the average market price of the common shares. For the three months ended March 31, 2012, 693,038 options and a warrant to purchase 276,815 shares of common stock were excluded from the net income per share calculations for the same reason.

Note 14 - Contingent Liabilities, Commitments, and Uncertainties

Litigation

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

Commitments

Effective October 2008, the Bank entered into an agreement with a third party to provide data processing services through October 31, 2015, at a monthly charge of approximately $115,000. The contract stipulates the Company is liable for a penalty in the event of early termination. The early termination penalty ratably declines as the contract matures.

Risks and Uncertainties

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

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

Financial Instruments with Off-Balance-Sheet-Risk

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

(in thousands)
	March 31 2013		December 31 2012
	June 30 2013		December 31 2012
Commitments to extend credit	$	3940,~~580~~277	$	38,762
Standby letters of credit		224		251
Total	$	3940,~~804~~501	$	39,013

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

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

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

Concentrations of Credit Risk

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

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

Recently, banking regulators have raised concern and have heightened regulatory scrutiny regarding loan portfolios with concentrations of loans collateralized by real estate, particularly commercial real estate (CRE). They have defined CRE to include construction loans, acquisition and development loans, loans collateralized with tracts of raw land for speculative purposes, any sort of commercial premise unless it is owner occupied and a number of other subcategories. Approximately 90% of the Bank’s loan portfolio is collateralized by real estate.

In addition to monitoring potential concentrations of loans to particular borrowers or groups of borrowers, industries, geographic regions and loan types, management monitors exposure to credit risk from other lending practices such as loans that subject borrowers to substantial payment increases (e.g. principal deferral periods, loans with initial interest-only periods, etc.) and loans with high loan-to-value ratios (LTV). Regulatory guidelines state that the total amount of all loans in excess of the regulatory loan-to-value ratio limits should not exceed 100% of a bank’s total risk-based capital. These types of loans totaled $2423.8 million at ~~March~~June 3130, 2013, representing ~~101~~91.96% of the Bank’s total risk-based capital. At December 31, 2012, loans in excess of the regulatory loan-to-value ratio limits totaled $26.8 million, or 111.8% of total risk-based capital.

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

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

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Note 15 - Stock Based Compensation

Stock Option Plans

The Employee Stock Option Plan and the Director Stock Option Plan provide up to 497,110 shares (adjusted for all stock splits) of the Company’s common stock may be issued under each of these plans for a combined total of 994,220 shares. Options granted under the Employee Stock Option Plan and the Director Stock Option Plan may be vested immediately and expire no more than 10 years from date of grant. The exercise price for any options granted under these plans is set by the Board of Directors at the date of grant (and is adjusted on a pro rata basis for any subsequent stock split). No options were granted or exercised under either the Director Stock Option Plan or Employee Stock Option Plan during the ~~three~~six months ended ~~March~~June 3130, 2013, during which period ~~781~~1,954 options were forfeited. It is the Company’s policy to issue shares to satisfy option exercises. The total number of options outstanding at ~~March~~June 3130, 2013, was 497,110 in the Director Stock Option Plan and ~~192~~191,~~998~~825 in the Employee Stock Option Plan.

No stock compensation expense was recognized by the Company during the first ~~three~~six months of 2013 or 2012 related to the vesting of stock options and as of ~~March~~June 3130, 2013, there was no unrecognized compensation cost related to outstanding stock options. There is no intrinsic value in these stock options as of ~~March~~June 3130, 2013, as the exercise prices are greater than the last traded price of the Company's common stock.

A summary of the activity in the Company’s Stock Option Plans and related information for the ~~three~~six months ended ~~March~~June 3130, 2013 is as follows:

	Outstanding Options					Exercisable Options
	Number Outstanding			Weighted Average Exercise Price		Number Outstanding			Weighted Average Exercise Price
				Weighted					Weighted
				Average					Average
	Number			Exercise		Number			Exercise
	Outstanding			Price		Outstanding			Price
At December 31, 2012		690,889		$	8.30		690,889		$	8.30
Options granted		-			-		-			-
Options vested		-			-		-			-
Options forfeited		(~~781~~1,954	)		13.31		(~~781~~1,954	)		13.31
At March 31, 2013		690,108		$	8.29		690,108		$	8.29
At June 30, 2013		688,935		$	8.29		688,935		$	8.29

								Weighted Average Remaining Contractual Life (in Years)
						Average Intrinsic Value
		Number Outstanding		Number Exercisable
Exercise Price
$	5.63		457,898		457,898	$	-		1.24
$	13.31		213,904		213,904		-		2.50
$	14.08		12,056		12,056		-		2.24
$	20.60		6,250		6,250		-		2.67
Total			690,108		690,108	$	-		1.66

Additional information concerning outstanding options under the Company’s Plans as of June 30, 2013, is as follows:


							Weighted Average
					Average		Remaining
	Number		Number		Intrinsic		Contractual Life
Exercise Price	Outstanding		Exercisable		Value		(in Years)
$5.63		457,898		457,898	$	-		0.99
$13.31		212,731		212,731		-		2.25
$14.08		12,056		12,056		-		1.99
$20.60		6,250		6,250		-		2.42
Total		688,935		688,935	$	-		1.41

Service-Based Awards

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

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Nonvested share activity under the Plan for the ~~three~~six months ended ~~March~~June 3130, 2013, is as follows:

				Weighted
				Average
				Grant Date
	Shares			Fair Value
Outstanding at December 31, 2012		159,867		$	0.55
Granted		-			-
Vested		(3771,~~922~~381	)		0.9874
Forfeited		-(2,000	)		-5.52
Outstanding at March 31, 2013		121,945		$	0.41
Outstanding at June 30, 2013		86,486		$	0.27

Compensation expense recognized for nonvested service-based shares totaled $58,000 and $918,000, respectively, for the ~~three~~six months ended ~~March~~June 3130, 2013 and 2012. Separately, during the first ~~three~~six months of 2013 and 2012, $2210,000 and $36,000, respectively, of stock compensation expense was reversed upon the forfeiture of nonvested service-based shares. As of ~~March~~June 3130, 2013, there was $128,000 of total unrecognized compensation cost related to service-based nonvested share-based compensation arrangements granted under the Omnibus Plan. This cost is expected to be recognized over a remaining weighted-average period of 310.46 months.

Note 16 - Fair Value of Financial Instruments

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

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

Fair value estimates are made at a specific point in time based on relevant market information about the financial instrument. These estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holding of a particular financial instrument. In cases where quoted market prices are not available, fair value estimates are based on judgments regarding future expected loss experience, current economic conditions, risk characteristics of various financial instruments and other factors. These estimates are subjective in nature and involve uncertainties and matters of significant judgment and, therefore, cannot be determined with precision. The methods and assumptions used to estimate the fair value of each class of financial instrument are summarized in Note 19 of the Company’s filing on Form 10-K for the year ended December 31, 2012. Changes in assumptions could significantly affect the estimates. In addition, the tax ramifications related to the realization of the unrealized gains and losses can have a significant effect on fair value estimates and have not been considered in the estimates. Finally, the fair value estimates presented herein are based on pertinent information available to management as of ~~March~~June 3130, 2013 and December 31, 2012.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

Assets Measured at Fair Value on a Recurring Basis

Fair values for investment securities are based on quoted market price if such information is available. If a quoted market price is not available, fair value is estimated using quoted market prices for similar securities. Investment securities are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using matrix pricing, which is a mathematical technique used widely in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities’ relationship to other benchmark quoted securities.

(in thousands)
			March 31, 2013
			June 30, 2013
	March 31 2013		Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
	Total		Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available-for-sale securities:
U.S. government agencies	$	5323,~~639~~320	$	-	$	5323,~~639~~320	$	-
Government-sponsored enterprises		~~150~~42,~~802~~358		-		~~150~~42,~~802~~358		-
Mortgage-backed securities		4438,~~304~~864		-		4438,~~304~~864		-
Total	$	~~248~~104,~~745~~542	$	-	$	~~248~~104,~~745~~542	$	-
			December 31, 2012
		Total	Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available-for-sale securities:
U.S. government agencies	$	39,069	$	-	$	39,069	$	-
Government-sponsored enterprises		167,913		-		167,913		-
Mortgage-backed securities		46,847		-		46,847		-
Total	$	253,829	$	-	$	253,829	$	-

			December 31, 2012
	December 31 2012		Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Available-for-sale securities:
U.S. government agencies	$	39,069	$	-	$	39,069	$	-
Government-sponsored enterprises		167,913		-		167,913		-
Mortgage-backed securities		46,847		-		46,847		-
Total	$	253,829	$	-	$	253,829	$	-

The Company had no liabilities carried at fair value or measured at fair value on a recurring basis at June 30, 2013 or December 31, 2012.

The Company had no liabilities carried at fair value or measured at fair value on a recurring basis at March 31, 2013 or December 31, 2012.

Assets Measured at Fair Value on a Nonrecurring Basis

Impaired loans are evaluated and valued at the time the loan is identified as impaired, and are carried at the lower of cost or market value. Market value is measured based on the value of the collateral securing these loans or net present value of expected future cash flows discounted at the loan’s effective interest rate. Collateral may be real estate and/or business assets, including equipment, inventory, and/or accounts receivable. The value of business equipment, inventory, and accounts receivable collateral is based on net book value on the business’ financial statements and, if necessary, discounted based on management’s review and analysis. Appraised and reported values may be discounted based on management’s historical knowledge, changes in market conditions from the time of valuation, and/or management’s expertise and knowledge of the client and the client’s selling costs and other expenses. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above.

Foreclosed real estate is adjusted to fair value, less estimated carrying costs and costs to sell, upon transfer of the loans to foreclosed real estate. Subsequently, foreclosed real estate is carried at the lower of the carrying value or the fair value, less estimated carrying costs and costs to sell. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the collateral.

Mortgage loans held for sale are carried at the lower of cost or fair value. The fair value of mortgage loans held for sale is based on what secondary markets are currently offering for portfolios with similar characteristics.33

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

June 30, 2013

~~Assets~~Mortgage ~~measured~~loans held for sale are carried at the lower of cost or fair value. The onfair avalue ~~non-recurring~~of ~~basis~~mortgage asloans ofheld ~~March~~for ~~31,~~sale ~~2013~~is ~~and~~based ~~December~~on ~~31,~~what ~~2012~~secondary markets are ascurrently ~~follows:~~offering for portfolios with similar characteristics.

(in thousands)
			March 31, 2013
	March 31 2013		Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans:
Construction and land development	$	10,116	$	-	$	10,116	$	-
1-4 family residential		9,121		-		9,121		-
Nonfarm, non residential		17,431		-		17,431		-
Total impaired real estate loans		36,668				36,668		-
Commercial and industrial		4,209		-		4,209		-
Consumer		45		-		45		-
Total impaired loans		40,922		-		40,922		-
Mortgage loans held for sale		3,142		-		3,142		-
Foreclosed real estate		15,733		-		15,733		-
Total	$	59,797	$	-	$	59,797	$	-

Assets measured at fair value on a non-recurring basis as of June 30, 2013 and December 31, 2012 are as follows:

(in thousands)
			June 30, 2013
			Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans:
Construction and land development	$	7,538	$	-	$	7,538	$	-
1-4 family residential		7,644		-		7,644		-
Nonfarm, nonresidential		15,789		-		15,789		-
Total impaired real estate loans		30,971				30,971		-
Commercial and industrial		4,015		-		4,015		-
Consumer		46		-		46		-
Total impaired loans		35,032		-		35,032		-
Mortgage loans held for sale		2,549		-		2,549		-
Foreclosed real estate		13,585		-		13,585		-
Total	$	51,166	$	-	$	51,166	$	-
			December 31, 2012
	December 31 2012		Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
			Quoted Market Price in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Impaired loans:
Construction and land development	$	13,842	$	-	$	13,842	$	-
1-4 family residential		8,137		-		8,137		-
Nonfarm, non residential		19,334		-		19,334		-
Nonfarm, nonresidential		19,334		-		19,334		-
Total impaired real estate loans		41,313				41,313
Commercial and industrial		4,312		-		4,312		-
Consumer		46		-		46		-
Total impaired loans		45,671		-		45,671		-
Mortgage loans held for sale		5,805		-		5,805		-
Foreclosed real estate		9,821		-		9,821		-
Total	$	61,297	$	-	$	61,297	$	-

The Company had no liabilities carried at fair value or measured at fair value on a nonrecurring basis at ~~March~~June 3130, 2013 or December 31, 2012.

Carrying Amounts and Estimated Fair Value of Financial Assets and Liabilities Not Measured at Fair Value

The following table presents the carrying values and estimated fair values of the Company’s other financial instruments as of the dates indicated, all of which are considered Level 3 fair value estimates. These fair value estimates are subject to fluctuation based on the amount and timing of expected cash flows as well as the choice of discount rate used in the present value calculation. This table excludes financial instruments for which the carrying amount approximates fair value. Since the fair value is estimated as of the balance sheet date, the amounts that will actually be realized or paid upon settlement or maturity of these instruments could be significantly different. In addition, any income taxes, or other expenses, which would be incurred in an actual sale or settlement, are not taken into consideration in the fair values presented.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

(in thousands)
	March 31, 2013				December 31, 2012
			Estimated				Estimated
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial instruments-assets
Loans (1)	$	322,925	$	323,375	$	331,296	$	332,764
Financial instruments-liabilities
Deposits		671,300		668,644		683,840		681,389
(1) includes loans, net, less impaired loans valued based on the underlying collateral

June 30, 2013

(in thousands)
	June 30, 2013				December 31, 2012
			Estimated				Estimated
	Carrying		Fair		Carrying		Fair
	Amount		Value		Amount		Value
Financial instruments-assets
Loans (1)	$	317,759	$	315,890	$	331,296	$	332,764
Financial instruments-liabilities
Deposits	$	668,879	$	664,312	$	683,840	$	681,389

(1) includes loans, net, less impaired loans valued based on the underlying collateral

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

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

There were no transfers of assets measured at fair value between Level 1 and Level 2 measurements during the ~~three~~six months ended ~~March~~June 3130, 2013.

Note 17 - Stockholders’ Equity

Preferred Stock

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

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

The Preferred Stock has a preference over the Company’s common stock upon liquidation. Dividends on the Preferred Stock, if declared, are payable quarterly in arrears. The Company’s ability to declare or pay dividends on, or purchase, redeem or otherwise acquire, its common stock is subject to certain restrictions in the event the Company fails to pay or set aside full dividends on the preferred stock for the latest completed dividend period.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

~~Due~~June ~~to insufficient funding at the holding company level and restrictions placed on it under the Consent Order and the Written Agreement~~30, ~~the Company has deferred the payment of the last 11 quarterly dividends on the Preferred Stock, with the total amount deferred equaling $2.3 million as of March 31,~~ 2013. ~~Until the Company pays in full these deferred Preferred Stock dividends, no dividends may be paid on the common stock.~~

Due to insufficient funding at the holding company level and restrictions placed on it under the Consent Order and the Written Agreement, the Company has deferred the payment of the last 12 quarterly dividends on the Preferred Stock, with the total amount deferred equaling $2.5 million as of June 30, 2013. Until the Company pays in full these deferred Preferred Stock dividends, no dividends may be paid on the common stock.

Restriction on Dividends

As a North Carolina banking corporation, the Company may not pay cash dividends if it is “undercapitalized” (as that term is defined in the Federal Deposit Insurance Act) or would become undercapitalized after making the payment. Regulatory authorities may further limit payment of dividends when it is determined that such a limitation is in the public interest and is necessary to ensure a bank’s financial soundness. As discussed in Note 2, the Bank is restricted from paying dividends without the approval of the FDIC and the Commissioner.

As discussed in Note 2, the Company is also restricted from paying dividends without the approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve.

Capital Requirements

The Company and the Bank are subject to various regulatory capital requirements administered by federal and state banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory (and possibly additional discretionary) actions by regulators that, if undertaken, could have a direct material effect on the Company’s and the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices.

The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. Quantitative measures established by regulation to ensure capital adequacy require the Company and the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital to risk-weighted assets, and of Tier I capital to average assets, as all those terms are defined in the applicable regulations.

As of ~~March~~June 3130, 2013, the most recent notification from the Bank’s primary regulator categorized the Bank as “~~significantly~~ undercapitalized” under the regulatory framework for prompt corrective action. Since that date, no conditions or events have occurred of which the Company is aware, that have resulted in a material change in the Company’s or the Bank’s category.

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1st Financial Services Corporation

Notes to Consolidated Financial Statements (Unaudited)

~~The~~June ~~table below summarizes the Company and the Bank’s capital ratios at March 31~~30, 2013 ~~and December 31, 2012.~~

											To be "Well Capitalized"
						For Capital Adequacy					Under Prompt Corrective
	Actual					Purposes					Action Provisions
(dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of March 31, 2013
Total Capital (to Risk-weighted Assets)
Company	$	24,343		6.42	%	$	30,355		8.00	%		n/a		n/a
Bank		24,308		6.41	%		30,355		8.00	%	$	37,944		10.00	%
Tier I Capital (to Risk-weighted Assets)
Company	$	19,525		5.15	%	$	15,178		4.00	%		n/a		n/a
Bank		19,490		5.14	%		15,178		4.00	%	$	22,767		6.00	%
Tier I Capital (to Average Assets)
Company	$	19,525		2.81	%	$	27,806		4.00	%		n/a		n/a
Bank		19,490		2.80	%		27,806		4.00	%	$	34,757		5.00	%
As of December 31, 2012
Total Capital (to Risk-weighted Assets)
Company	$	24,029		6.11	%	$	31,438		8.00	%		n/a		n/a
Bank		24,014		6.11	%		31,438		8.00	%	$	39,298		10.00	%
Tier I Capital (to Risk-weighted Assets)
Company	$	19,045		4.85	%	$	15,719		4.00	%		n/a		n/a
Bank		19,030		4.84	%		15,719		4.00	%	$	23,579		6.00	%
Tier I Capital (to Average Assets)
Company	$	19,045		2.64	%	$	28,822		4.00	%		n/a		n/a
Bank		19,030		2.64	%		28,822		4.00	%	$	36,028		5.00	%

The table below summarizes the Company and the Bank’s capital ratios at June 30, 2013 and December 31, 2012.

											To be "Well Capitalized"
						For Capital Adequacy					Under Prompt Corrective
	Actual					Purposes					Action Provisions
(dollars in thousands)	Amount		Ratio			Amount		Ratio			Amount		Ratio
As of June 30, 2013
Total Capital (to Risk-weighted Assets)
Company	$	25,917		6.98	%	$	29,708		8.00	%		n/a		n/a
Bank		25,892		6.97	%		29,708		8.00	%	$	37,135		10.00	%
Tier I Capital (to Risk-weighted Assets)
Company	$	21,202		5.71	%	$	14,854		4.00	%		n/a		n/a
Bank		21,177		5.70	%		14,854		4.00	%	$	22,281		6.00	%
Tier I Capital (to Average Assets)
Company	$	21,202		3.05	%	$	27,816		4.00	%		n/a		n/a
Bank		21,177		3.05	%		27,816		4.00	%	$	34,770		5.00	%

As of December 31, 2012
Total Capital (to Risk-weighted Assets)
Company	$	24,029		6.11	%	$	31,438		8.00	%		n/a		n/a
Bank		24,014		6.11	%		31,438		8.00	%	$	39,298		10.00	%
Tier I Capital (to Risk-weighted Assets)
Company	$	19,045		4.85	%	$	15,719		4.00	%		n/a		n/a
Bank		19,030		4.84	%		15,719		4.00	%	$	23,579		6.00	%
Tier I Capital (to Average Assets)
Company	$	19,045		2.64	%	$	28,822		4.00	%		n/a		n/a
Bank		19,030		2.64	%		28,822		4.00	%	$	36,028		5.00	%

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1st Financial Services Corporation

Management'’s Discussion and Analysis

~~ITEM~~June ~~2. MANAGEMENT’S~~30, ~~DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS~~2013

~~Introduction~~ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

Introduction

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

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

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

Management has provided the following discussion and analysis to address information about the Company’s financial condition and results of operations, which may not otherwise be apparent from the consolidated financial statements included in this Report. Reference should be made to those statements for an understanding of the following discussion and analysis. The following discussion and analysis should be read in conjunction with the consolidated financial statements and the notes thereto located herein and in the Company’s filing on Form 10-K for the year ended December 31, 2012.

Factors That May Affect Future Results

The following discussion contains certain forward-looking statements about the Company’s financial condition and results of operations, which are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in the forward-looking statements. Those statements may be identified by the use of terms such as “may”, “will”, “should”, “could,” “plans”, “intends”, “anticipates”, “expects”, “believes”, “estimates”, “predicts”, “forecasts”, “potential” or “continue,” or similar terms or the negative of these terms, or other statements concerning opinions or judgments of our management about future events. Readers are cautioned not to place undue reliance on these forward-looking statements, which reflect management’s judgment only as of the date hereof. The Company undertakes no obligation to publicly revise these forward-looking statements to reflect events and circumstances that arise after the date hereof. Factors that may cause actual results to differ materially from those contemplated by such forward-looking statements include, among others, the following possibilities: (1) there is substantial doubt about the ability of 1st Financial to continue as a going concern; (2) 1st Financial and its subsidiary, Mountain 1st Bank and Trust Company (the Bank) may be subject to additional, heightened enforcement actions, and ultimately the Bank may be placed under conservatorship or receivership if we do not raise additional capital or otherwise comply with the Consent Order (the Consent Order) with the Federal Deposit Insurance Corporation (FDIC) and the North Carolina Commissioner of Banks (the Commissioner) and the Written Agreement (the Written Agreement), with the Federal Reserve Bank of Richmond (Federal Reserve Bank), or if our condition deteriorates; (3) we need to raise additional capital in the future in order to satisfy regulatory requirements, but that capital may not be available when it is needed; (4) the impact of the extensive reforms enacted in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd-Frank Act), the precise nature, extent, and timing of many of these reforms and the impact on us is still uncertain; (5) competitive pressure among depository institutions increases significantly; (6) further credit quality deterioration, which could cause an increase in the provisions for loan losses; (7) general economic conditions, particularly those affecting real estate values, either nationally or in the market area in which we do or anticipate doing business, are worse than expected; (8) regulatory limitations or prohibitions with respect to the operations or activities of the Company and/or the Bank; (9) revenues are lower than expected; (10) the availability of and/or an unexpectedly high cost of additional capital; (11) the effects of the FDIC deposit insurance premiums and assessments; (12) the effects of and changes in monetary and fiscal policies and laws, including the interest rate policies of the Federal Reserve Board; (13) volatility in the credit or equity markets and its effect on the general economy; (14) demand for the products or services of the Company, as well as its ability to attract and retain qualified people; (15) the effect of other requirements in the Consent Order and the Written Agreement to which we are subject and any further regulatory actions; (16) the costs and effects of legal, accounting, and regulatory developments and compliance, including the Consent Order and the Written Agreement; and (17) premiums for D&O insurance may increase: we may be unable to renew our D&O insurance policy on acceptable terms. See also those risk factors identified in the section headed “Risk Factors”, beginning on page 18 of the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2012, filed with the Securities and Exchange Commission (SEC) on March 5, 2013 (the Annual Report). The Company undertakes no obligation to update any forward-looking statement, whether written or oral, which may be made from time to time by or on behalf of the Company.

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1st Financial Services Corporation

Management'’s Discussion and Analysis

June 30, 2013

Enforcement Policies and Actions

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

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

Enforcement Action - Consent Order

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

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

●

the Board of Directors of the Bank will enhance its supervision of the Bank’s activities, including by increasing the formality of its meetings and appointing a special Directors’ Committee. The Committee will oversee the efforts of the Bank’s management in complying with the Consent Order and will regularly report to the full Board.

●

the Bank Board will assess the Bank’s management team to ensure the Bank’s executive officers have the skills, training, abilities, and experience needed to cause the Bank to comply with the Consent Order, operate in a safe and sound manner, comply with applicable laws and regulations, and strengthen all areas of the Bank’s operations that are not currently in compliance with the Consent Order. The Board will also assess the Bank’s management and staffing needs in order to determine if additional resources should be added to the management team.

●	during the effectiveness of the Consent Order, the Bank will maintain Tier 1 Capital of at least 8% of total assets, a Total Risk Based Capital Ratio of at least 12%, and a fully funded allowance for loan and lease losses (the “Allowance for Loan Losses” or “Allowance”).

●	the Bank will develop and implement a plan for achieving and maintaining the foregoing capital levels, which plan may include sales of stock by the Company and contributions of the sales proceeds by the Company to the capital of the Bank.

●

the Board will strengthen the Allowance for Loan Losses policy of the Bank, periodically review the Bank’s Allowance for Loan Losses to determine its adequacy and enhance its periodic reviews of the Allowance to ensure its continuing adequacy. Deficiencies noted will be promptly remedied by charges to earnings.

1st Financial Services Corporation

Management's Discussion and Analysis

●	the Bank will develop and implement a strategic plan covering at least three years and containing long-term goals designed to improve the condition of the Bank.

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1st Financial Services Corporation

Management’s Discussion and Analysis

June 30, 2013

●

the Bank will not extend additional credit to any borrower who had a loan with the Bank that was charged off or who has a current loan that is classified “Loss” or “Doubtful”. The Bank also will not extend additional credit to any borrower who has a current loan that is classified “Substandard” or listed for “Special Mention.” A further extension of credit may be made to a borrower with a “Substandard” or “Special Mention” loan if the Bank Board determines such extension would be in the best interests of the Bank.

●

the Bank will formulate a detailed plan to collect, charge off or improve the quality of each of its “Substandard” or “Doubtful” loans as of August 31, 2009, of more than $250,000 and will promptly implement the plan. The Board will closely monitor the Bank’s progress in fulfilling the requirements of this plan.

●

the Bank will reduce loans in excess of $250,000 and classified as “Substandard” or “Doubtful” in accordance with a schedule required by the supervisory authorities. The schedule targets an aggregate reduction by 75% within 720 days of the effectiveness of the Consent Order. The Board will monitor this effort on a monthly basis.

●	the Bank will cause full implementation of its loan underwriting, loan administration, loan documentation, and loan portfolio management policies within 90 days of the effectiveness of the Consent Order.

●	the Bank will adopt a loan review and grading system within 90 days of the Consent Order to provide for effective periodic reviews of the Bank’s loan portfolio. The system shall address, among other things, loan grading standards, loan categorization, and credit risk analyses.

●

within 30 days of the effectiveness of the Consent Order, the Bank will develop a plan to systematically reduce the concentration of a significant portion of its extensions of credit in a limited group of borrowers. Additionally, the Bank will prepare a risk segmentation analysis with respect to certain real estate industry concentrations of credit identified by the supervisory authorities.

●	the Bank will enhance its review of its liquidity by engaging in monthly analyses. It will also develop and implement a liquidity contingency and asset/liability management plan.

●	within 90 days from the effectiveness of the Consent Order, the Bank will implement a plan and 2010 budget designed to improve its net interest margin, increase interest income, reduce expenditures, and improve and sustain earnings.

●	the Bank will implement internal routine and control policies addressing concerns raised by its supervisory authorities and designed to enhance its safe and sound operation.

●	within 90 days of the Consent Order, the Bank will implement a comprehensive internal audit program and cause an effective system of internal and external audits to be in place.

●	the Bank will implement a policy for managing its “owned real estate”.

●	the Bank will forebear from soliciting and accepting “brokered deposits” unless it first receives an appropriate waiver from the FDIC; and will comply with restrictions issued by the FDIC on the effective yields of deposit products offered by, among others, banks subject to consent orders.

●	a limit upon growth of 10% per year will be observed by the Bank.

●	the Bank will not pay dividends or make other forms of payment reducing capital to the Company without the prior approval of the supervisory authorities while the Consent Order is in effect.

~~● the Bank will implement policies to enhance the Board’s focus on conflicts of interest regulations and its handling of transactions with officers and directors.~~40

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1st Financial Services Corporation

Management'’s Discussion and Analysis

June 30, 2013

●	the Bank will implement policies to enhance the Board’s focus on conflicts of interest regulations and its handling of transactions with officers and directors.

●	the Bank will correct any violations of laws and regulations identified by the supervisory authorities.

●	the Bank will make quarterly progress reports to the supervisory authorities detailing the form and manner of actions taken to comply with the Consent Order.

The foregoing description is a summary of the material terms of the Consent Order and is qualified in its entirety by reference to the Consent Order. A copy of the Consent Order has been filed with the SEC and is available on the SEC’s Internet website at www.sec.gov. The Consent Order will remain in effect until modified or terminated by the FDIC and the Commissioner.

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

Enforcement Action – Written Agreement

As a direct consequence of the issuance of the Consent Order and the requirement the Company serve as a source of strength for the Bank, 1st Financial executed a written agreement (the Written Agreement) with the Federal Reserve Bank, effective October 13, 2010.

●

the Board of Directors of 1st Financial shall take appropriate steps to fully utilize 1st Financial’s financial and managerial resources, to serve as a source of strength to the Bank, including, but not limited to, taking steps to ensure the Bank complies with the Consent Order and any other supervisory action taken by the Bank’s federal or state regulator.

●	1st Financial shall not declare or pay any dividends without the prior written approval of the Federal Reserve Bank and the Director of the Division of Banking Supervision and Regulation of the Federal Reserve Bank.

●	1st Financial shall not directly or indirectly take dividends or any other form of payment representing a reduction in capital from the Bank without the prior written approval of the Federal Reserve Bank.

●

all requests for prior approval shall be received by the Federal Reserve Bank at least 30 days prior to the proposed dividend declaration date. All requests shall contain, at a minimum, current, and projected information on 1st Financial’s capital, earnings, and cash flow; the Bank’s capital, asset quality, earnings, and allowance for loan and lease losses; and identification of the sources of funds for the proposed payment or distribution.

●

1st Financial shall not, directly or indirectly, incur, increase, or guarantee any debt without the prior written approval of the Federal Reserve Bank. All requests for prior written approval shall contain, but not be limited to, a statement regarding the purpose of the debt, the terms of the debt, and the planned source(s) for debt repayment, and an analysis of the cash flow resources available to meet such debt repayment.

●	1st Financial shall not, directly or indirectly, purchase or redeem any shares of its stock without the prior written approval of the Federal Reserve Bank.

●	within 60 days of the Written Agreement, 1st Financial shall submit to the Federal Reserve Bank an acceptable written plan to maintain sufficient capital at 1st Financial on a consolidated basis. The plan shall, at a minimum, address, consider, and include:

Ø the consolidated organization’s and the Bank’s current and future capital requirements, including compliance with the Capital Adequacy Guidelines for Bank Holding Companies and the applicable capital adequacy guidelines for the Bank issued by the Bank’s federal regulator;41

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1st Financial Services Corporation

Management'’s Discussion and Analysis

June 30, 2013

Ø	the consolidated organization’s and the Bank’s current and future capital requirements, including compliance with the Capital Adequacy Guidelines for Bank Holding Companies and the applicable capital adequacy guidelines for the Bank issued by the Bank’s federal regulator;

Ø	the adequacy of the Bank’s capital, taking into account the volume of classified credits, concentrations of credit, allowance for loan and lease losses, current and projected asset growth, and projected retained earnings;

Ø	the source and timing of additional funds necessary to fulfill the consolidated organization’s and the Bank’s future capital requirements;

Ø	supervisory requests for additional capital at the Bank or the requirements of any supervisory action imposed on the Bank by its federal regulator; and

Ø	the requirements of Regulation Y of the Federal Reserve that 1st Financial serve as a source of strength to the Bank.

●

1st Financial shall notify the Federal Reserve Bank, in writing, no more than 45 days after the end of any quarter in which any of 1st Financial’s capital ratios fall below the approved plan’s minimum ratios. Together with the notification, 1st Financial shall submit an acceptable written plan that details the steps that 1st Financial will take to increase 1st Financial’s capital ratios to or above the approved plan’s minimums.

●

within 60 days of the Written Agreement, 1st Financial shall submit to the Federal Reserve Bank a written statement of its planned sources and uses of cash for debt service, operating expenses, and other purposes (Cash Flow Projection) for 2011. 1st Financial shall submit to the Federal Reserve Bank a Cash Flow Projection for each calendar year subsequent to 2011 at least one month prior to the beginning of that calendar year.

●

in appointing any new director or senior executive officer, or changing the responsibilities of any senior executive officer so that the officer would assume a different senior executive officer position, 1st Financial shall comply with the notice provisions of the Federal Deposit Insurance Act (the FDI Act) and Regulation Y of the Federal Reserve.

●	1st Financial shall comply with the restrictions on indemnification and severance payments of the FDI Act and the FDIC’s regulations.

●

within 30 days after the end of each calendar quarter following the date of the Written Agreement, the Board of Directors shall submit to the Federal Reserve Bank written progress reports detailing the form and manner of all actions taken to secure compliance with the provisions of the Written Agreement and the results thereof, and a parent company only balance sheet, income statement, and, as applicable, report of changes in stockholders’ equity.

●

1st Financial shall submit a written capital plan that is acceptable to the Federal Reserve Bank within the applicable time period set forth in the Written Agreement. Within 10 days of approval by the Federal Reserve Bank, 1st Financial shall adopt the approved capital plan. Upon adoption, 1st Financial shall promptly implement the approved plan, and thereafter fully comply with it. During the term of the Written Agreement, the approved capital plan shall not be amended or rescinded without the prior written approval of the Federal Reserve Bank.

The foregoing description is a summary of the material terms of the Written Agreement and is qualified in its entirety by reference to the Written Agreement. A copy of the Written Agreement has been filed with the SEC and is available on the SEC’s Internet website at www.sec.gov. Each provision of the Written Agreement shall remain effective and enforceable until stayed, modified, terminated, or suspended in writing by the Federal Reserve Bank.

~~"Significantly Undercapitalized" Capital Category~~42

AtBack ~~March~~to ~~31, 2013, the Bank was deemed~~ "~~significantly~~Table ~~undercapitalized". As such, the Bank is subject to the restrictions in Section 38~~ of ~~the Federal Deposit Insurance Act and the related FDIC rules and regulations that apply to~~ Contents"~~significantly undercapitalized" institutions, including restrictions on:~~

1st Financial Services Corporation

Management'’s Discussion and Analysis

June 30, 2013

"Undercapitalized" Capital Category

At June 30, 2013, the Bank was deemed "undercapitalized". As such, and having failed to implement its capital restoration plan, the Bank is subject to the restrictions in Section 38 of the Federal Deposit Insurance Act and the related FDIC rules and regulations that apply to “significantly undercapitalized” institutions, and "undercapitalized" institutions that fail to submit and implement capital restoration plans, including restrictions on:

●	the compensation paid to senior executive officers;

● capital distributions; ● payment of management fees;

● payment of management fees;

●	asset growth;

●	acquiring any interest in any company or insured depository institution;

●	establishing or acquiring any additional branch office; and

●	engaging in any new line of business.

Because of its capital category, the Bank may not accept, renew, or roll over brokered deposits, and is subject to restrictions on the rate of interest it may pay on deposits. Also, as a consequence of the Consent Order, the Bank is deemed to be in a "troubled condition," as defined under the FDIC's rules and regulations, which further prohibits or limits certain golden parachute agreements and payments to management.

Going Concern Considerations

As discussed in Item 7 of the Company’s filing on Form 10-K for the year ended December 31, 2012, under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations", and in Note 2 to the accompanying consolidated financial statements, although the Company was profitable in 2012 and the first ~~quarter~~half of 2013, the Company has suffered recurring losses that have eroded regulatory capital ratios, and the Bank is under a Consent Order that requires, among other provisions, capital ratios to be maintained at certain heightened levels. In addition, the Company is under a Written Agreement that requires, among other provisions, the submission of a capital plan to improve the Company’s and the Bank’s capital levels. As of ~~March~~June 3130, 2013, both the Bank and the Company are considered “~~significantly~~ undercapitalized” based on their respective regulatory capital levels. These considerations raise substantial doubt about the Company's ability to continue as a going concern. These financial statements do not include any adjustments that would be necessary should the Company be unable to continue as a going concern.

Prompt Corrective Action

The FDIC has broad powers to take corrective action to resolve the problems of insured depository institutions. The extent of these powers will depend upon whether the institution in question is “well capitalized,” “adequately capitalized,” “undercapitalized,” “significantly undercapitalized,” or “critically undercapitalized.” The FDIC is required to take various mandatory supervisory actions, and is authorized to take other discretionary actions, with respect to banks in the three undercapitalized categories. The severity of supervisory action will depend upon the capital category in which a bank is placed. Generally, subject to a narrow exception, current federal law requires the FDIC to appoint a receiver or conservator for a bank that is critically undercapitalized.

Under the FDIC’s prompt corrective action rules, an institution is considered “well capitalized” if it has (i) a total risk-based capital ratio of 10.0% or greater, (ii) a Tier I risk-based capital ratio of 6.0% or greater, (iii) a leverage ratio of 5.0% or greater and (iv) is not subject to any order or written directive to meet and maintain a specific capital level for any capital measure. An “adequately capitalized” institution is defined as one that has (i) a total risk-based capital ratio of 8.0% or greater, (ii) a Tier I risk-based capital ratio of 4.0% or greater and (iii) a leverage ratio of 4.0% or greater (or 3% or greater in the case of an institution with the highest examination rating). An institution is considered (A) “undercapitalized” if it has (i) a total risk-based capital ratio of less than 8%, (ii) a Tier I risk-based capital ratio of less than 4% or (iii) a leverage ratio of less than 4% (or 3% in the case of an institution with the highest examination rating); (B) “significantly undercapitalized” if the institution has (i) a total risk-based capital ratio of less than 6%, or (ii) a Tier I risk-based capital ratio of less than 3% or (iii) a leverage ratio of less than 3% and (C) “critically undercapitalized” if the institution has a ratio of tangible equity to total assets equal to or less than 2%.

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1st Financial Services Corporation

Management'’s Discussion and Analysis

June 30, 2013

A bank that is categorized as "undercapitalized, "significantly undercapitalized," or "critically undercapitalized," is required to submit an acceptable capital restoration plan to the FDIC. An "undercapitalized" bank also is generally prohibited from increasing its average total assets, making acquisitions, establishing any branches, or engaging in any new line of business, except in accordance with an accepted capital restoration plan or with the approval of the FDIC. In addition, the FDIC is given authority with respect to any "undercapitalized" bank to take any of the actions it is required to or may take with respect to a "significantly undercapitalized" bank if it determines those actions are necessary to carry out the purpose of the law.

At ~~March~~June 3130, 2013, the Bank was deemed "~~significantly~~ undercapitalized". As such, and having failed to implement its capital restoration plan, the Bank is subject to certain restrictions, as discussed under “"~~Significantly~~ Undercapitalized" Capital Category” in Item 1.

Regulatory Reform

Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act). On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) was signed into law. The Dodd-Frank Act was intended primarily to overhaul the financial regulatory framework following the global financial crisis and has impacted, and will continue to impact, all financial institutions, including 1st Financial and the Bank. The Dodd-Frank Act contains provisions that have, among other things, established a Bureau of Consumer Financial Protection, established a systemic risk regulator, consolidated certain federal bank regulators, and imposed increased corporate governance and executive compensation requirements. The Dodd-Frank Act requires various federal agencies to adopt a broad range of new implementing rules and regulations and to prepare numerous studies and reports for the U.S. Congress. The federal agencies are given significant discretion in drafting and implementing regulations. Although some of these regulations have been promulgated, many additional regulations are expected to be issued in 2013 and thereafter. Consequently, many of the details and much of the impact of the Dodd-Frank Act may not be known for many months or years.

Critical Accounting Policies and Estimates

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

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

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

Our significant accounting policies are discussed in Note 1 to the audited consolidated financial statements for the year ended December 31, 2012, contained in the Company’s Annual Report on Form 10-K. Of those significant accounting policies, we have determined that accounting for our allowance for loan losses, foreclosed real estate, the realization of our deferred tax asset, and the determination of fair value of financial instruments are deemed critical because of the valuation techniques used and the sensitivity of the amounts recorded in our consolidated financial statements to the methods, assumptions, and estimates underlying these balances. Accounting for these critical areas requires subjective and complex judgments and could be subject to revision as new information becomes available. Reference should be made to the Annual Report for a detailed discussion of these critical accounting policies.

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1st Financial Services Corporation

Management'’s Discussion and Analysis

June 30, 2013

General Economic Conditions

Western North Carolina is undergoing one of the most severe economic recessions in our history. Unemployment is close to record levels and both residential and commercial real estate values have been adversely impacted. Since 2008, with the slowing economy, falling real estate values and reducing interest rates, our Company experienced severe stress on our earnings from both depressed margins and worsening asset quality. Continued weakness in the Western North Carolina real estate market was the primary reason for the Company’s providing an increase to the allowance for loan losses of $5.3 million and $15.8 million in 2012 and 2011, respectively. For the ~~three~~six-month period ended ~~March~~June 3130, 2013, the provision for loan losses totaled $940,000 with net charge-offs totaling $~~843,000~~1.1 million. We have experienced some margin contraction, as we are unable to reinvest proceeds from loan and security repayments at the same yields. We also expect to continue to incur increased expense as we manage our troubled assets. Our markets continue to feel the effects of the recession and we do not foresee substantial improvements in either unemployment or real estate values until late 2013 at the earliest.

Overview

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

The Company believes its current base of business is relatively well diversified as is the general economic base of the region as a whole. The principal concentration identified by management within the Company’s lending portfolio is in loans secured by real estate. At ~~March~~June 3130, 2013, loans collateralized by real estate comprised 90% of the Company’s total loan portfolio. Management believes concentration risk within this sector of the loan portfolio is mitigated by the mix of different types of real estate held as collateral. These include residential, multifamily, and both income-producing and owner-occupied commercial properties. The Company’s loan portfolio includes $6156.78 million in loans classified as construction or acquisition and development (of which $3835.30 million are land loans) and $~~141~~137.14 million in loans classified as commercial real estate (CRE), representing 1615.56% and 37.

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