General - First Defiance is a unitary thrift holding company that conducts
business through its two wholly owned subsidiaries, First Federal and First
Insurance. First Federal is a federally chartered savings bank that provides
financial services through 33 full service banking centers in communities based
in northwest Ohio, northeast Indiana, and southeastern Michigan. First Federal
provides a broad range of financial services including checking accounts,
savings accounts, certificates of deposit, real estate mortgage loans,
commercial loans, consumer loans, home equity loans and trust and wealth
management services through its extensive branch network. First Insurance sells
a variety of property and casualty, group health and life, and individual health
and life insurance products. Insurance products are sold through First
Insurance's offices in Defiance, Archbold, Bryan, Bowling Green, Maumee and
Oregon, Ohio areas.
Business Strategy - First Defiance's primary objective is to be a high
performing community banking organization, well regarded in its market areas.
First Defiance accomplishes this through emphasis on local decision making and
empowering its employees with tools and knowledge to serve its customers' needs.
First Defiance believes in a "Customer First" philosophy that is strengthened by
its Trusted Advisor initiative. First Defiance also has a tagline of "Bank with
the people you know and trust" as an indication of its commitment to local,
responsive, personalized service. First Defiance believes this strategy results
in greater customer loyalty and profitability through core relationships. First
Defiance is focused on diversification of revenue sources and increased market
penetration in areas where the growth potential exists for a balance between
acquisition and organic growth. The primary segments of First Defiance's
business strategy are commercial banking, consumer banking, including the
origination and sale of single family residential loans, enhancement of fee
income, wealth management and insurance sales, each united by a strong customer
service culture throughout the organization. In 2012, management intends to
continue to focus on asset quality, core deposit growth, expense control as well
as other opportunities to further service our customers.
Commercial and Commercial Real Estate Lending - Commercial and commercial real
estate lending have been an ongoing focus and a major component of First
Federal's success. First Federal provides primarily commercial real estate and
commercial business loans with an emphasis on owner occupied commercial real
estate and commercial business lending with a focus on the deposit balances that
accompany these relationships. First Federal's client base tends to be small to
middle market customers with annual gross revenues generally between $1 million
and $50 million. First Federal's focus is also on securing multiple guarantors
in addition to collateral where possible. These customers require First Federal
to have a high degree of knowledge and understanding of their business in order
to provide them with solutions to their financial needs. First Federal's
"Customer First" philosophy and culture complement the needs of its clients.
First Federal believes this personal service model differentiates First Federal
from its competitors, particularly the larger regional institutions. First
Federal offers a wide variety of products to support commercial clients
including remote deposit capture and other cash management services. First
Federal also believes that the small business customer is a strong market for
First Federal. First Federal participates in many of the Small Business
Administration lending programs. Maintaining a diversified portfolio with an
emphasis on monitoring industry concentrations and reacting to changes in the
credit characteristics of industries is an ongoing focus.
47
Consumer Banking - First Federal offers customers a full range of deposit and
investment products including demand, NOW, money market, certificates of
deposit, CDARS and savings accounts. First Federal offers a full range of
investment products through the wealth management department and a wide variety
of consumer loan products, including residential mortgage loans, home equity
loans, installment loans and education loans. First Federal also offers online
banking services, which include online bill pay along with debit cards.
Fee Income Development - Generation of fee income and the diversification of
revenue sources are accomplished through the mortgage banking operation,
insurance subsidiary and the wealth management department as First Defiance
seeks to reduce reliance on retail transaction fee income.
Deposit Growth -First Federal's focus has been to grow core deposits with an
emphasis on total relationship banking with both our retail and commercial
customers. First Federal has initiated a pricing strategy that considers the
whole relationship of the customer. First Federal will continue to focus on
increasing its market share in the communities it serves by providing quality
products with extraordinary customer service, business development strategies
and branch expansion. First Federal will look to grow its footprint in areas
believed to further complement its overall market share and complement its
strategy of being a high performing community bank.
Asset Quality - Maintaining a strong credit culture is of the utmost importance
to First Federal. First Federal has maintained a strong credit approval and
review process that has allowed the Company to maintain a credit quality
standard that balances the return with the risks of industry concentrations and
loan types. First Federal is primarily a collateral lender with an emphasis on
cash flow performance, while obtaining additional support from personal
guarantees and secondary sources of repayment. First Federal has focused its
attention on loan types and markets that it knows well and in which it has
historically been successful in. First Federal strives to have loan
relationships that are well diversified in both size and industry, and monitor
the overall trends in the portfolio to maintain its industry and loan type
concentration targets. First Federal maintains a problem loan remediation
process that focuses on detection and resolution. First Federal maintains a
strong process of internal control that subjects the loan portfolio to periodic
internal reviews as well as independent third party loan review.
Expansion Opportunities - First Defiance believes it is well positioned to take
advantage of acquisitions or other business opportunities in its market areas,
including FDIC-assisted transactions. First Defiance believes it has a track
record of successfully accomplishing both acquisitions and de novo branching in
its market area. This track record puts the Company in a solid position to enter
or expand its business. First Defiance has successfully integrated acquired
institutions in the past with the most recent financial institution acquisition
being completed in 2008. First Defiance will continue to be disciplined as well
as opportunistic in its approach to future acquisitions and de novo branching
with a focus on its primary geographic market area, which it knows well and has
been competing in for a long period of time. First Defiance completed its
acquisition of PDI, on July 1, 2011, which was merged into First Insurance with
offices located in Maumee and Oregon, Ohio.
48
Investments- First Defiance invests in U.S. Treasury and federal government
agency obligations, obligations of municipal and other political subdivisions,
mortgage-backed securities which are issued by federal agencies, corporate
bonds, and collateralized mortgage obligations ("CMOs") and real estate mortgage
investment conduits ("REMICs"). Management determines the appropriate
classification of all such securities at the time of purchase in accordancewith
FASB ASC Topic 320.
Securities are classified as held-to-maturity when First Defiance has the
positive intent and ability to hold the security to maturity. Held-to-maturity
securities are stated at amortized cost and had a recorded value of $600,000 at
June 30, 2012. Securities not classified as held-to-maturity are classified as
available-for-sale, which are stated at fair value and had a recorded value of
$278.8 million at June 30, 2012. The available-for-sale portfolio consists of
obligations of U.S. Government corporations and agencies ($24.8 million),
certain municipal obligations ($84.0 million), CMOs and REMICs ($70.9 million),
corporate bonds ($8.6 million), mortgage backed securities ($87.2 million), U.S.
treasury bonds ($2.0 million) and trust preferred and preferred stock ($1.4
million).
In accordance with ASC Topic 320, declines in the fair value of held-to-maturity
and available-for-sale securities below their cost that are deemed to be other
than temporary are reflected in earnings as realized losses to the extent the
impairment is related to credit losses. The amount of the impairment related to
other factors is recognized in other comprehensive income.
Lending - In order to properly assess the collateral dependent loans included in
its loan portfolio, the Company has established policies regarding the
monitoring of the collateral underlying such loans. The Company requires an
appraisal that is less than one year old for all new collateral dependent real
estate loans, and all renewed collateral dependent real estate loans where
significant new money is extended. The appraisal process is handled by the
Credit Department, which selects the appraiser and orders the appraisal. First
Defiance's loan policy prohibits the account officer from talking or
communicating with the appraiser to insure that the appraiser is not influenced
by the account officer in any way in making their determination of value.
First Federal generally does not require updated appraisals for performing loans
unless significant new money is requested by the borrower.
When a collateral dependent loan is downgraded to classified status, First
Federal reviews the most current appraisal on file and if necessary, based on
First Federal's assessment of the appraisal, such as age, market, etc, First
Federal will discount this amount to a more appropriate current value based on
inputs from lenders and realtors. This amount may then be discounted further by
First Federal's estimation of the carrying and selling costs. In some instances,
we may require a new appraisal. Finally, First Federal assesses whether there is
any collateral short fall, considering guarantor support and determines if
a
reserve is necessary.
When a collateral dependent loan moves to non-performing status, First Federal
generally gets a new third party appraisal and adjusts the reserve as necessary
based upon the new appraisal and an estimate of costs to liquidate the
collateral. All properties that are moved into the Other Real Estate Owned
("OREO") category are supported by current appraisals, and the OREO is carried
at the lower of cost or fair value, which is determined based on appraised value
less First Federal's estimate of the liquidation costs.
49
First Federal does not adjust any appraisals upward without written
documentation of this valuation change from the appraiser. When setting reserves
on classified loans, appraisal values may be discounted downward based upon
First Federal's experience with liquidating similar properties.
All loans over 90 days past due and/or on non-accrual as well as all Troubled
Debt Restructured loans are classified as non-performing loans. Non-performing
status automatically occurs in the month in which the 90 day delinquency occurs.
For Troubled Debt Restructured loans, the loans are put into non-performing
status in the month in which the restructure occurs.
As stated above, once a collateral dependent loan is identified as
non-performing, First Federal generally gets an appraisal. Troubled debt
restructure collateral dependent loans receive an appraisal as part of the
restructure credit decision.
Appraisals are received within approximately 60 days after they are requested.
The First Federal Loan Loss Reserve Committee reviews the amount of each new
appraisal and makes any necessary adjustment to the reserve at its meeting
prior
to the end of each quarter.
Any partially charged-off collateral dependent loans are considered
non-performing, and as such, would need to show an extended period of time with
satisfactory payment performance as well as cash flow coverage capability
supported by current financial statements before First Federal will consider an
upgrade to performing status. If the loan maintains a rate at restructuring that
is lower than the market rate for similar credits, the loan will remain
classified as troubled debt restructuring until such time as it is paid off or
restructured at prevailing rates and terms. First Federal may consider moving
the loan to accruing status after six months of satisfactory payment
performance.
For loans where First Federal determines that an updated appraisal is not
necessary, other means are used to verify the value of the real estate, such as
recent sales of similar properties on which First Federal had loans as well as
calls to appraisers, brokers, realtors and investors. First Federal monitors and
tracks its reserves quarterly to determine accuracy. Based on these results,
changes may occur in the processes used. The most recent analysis indicates that
our actual charge-offs are on average within 10% of the specific reserves
previously established for these loans.
Loan modifications constitute a troubled debt restructuring if First Federal for
economic or legal reasons related to the borrower's financial difficulties
grants a concession to the borrower that it would not otherwise consider. For
loans that are considered troubled debt restructurings, First Federal either
computes the present value of expected future cash flows discounted at the
original loan's effective interest rate or, as a practical expedient, it may
measure impairment based on the observable market price of the loan or the fair
value of the collateral even though troubled debt restructurings are not
expected to be deemed collateral dependent. If the troubled debt restructuring
is deemed collateral dependent, then reserves are calculated based on the fair
value of the collateral. The difference between the carrying value and fair
value of the loan is recorded as a valuation allowance.
50
Earnings - The profitability of First Defiance is primarily dependent on its net
interest income and non-interest income. Net interest income is the difference
between interest income on interest-earning assets, principally loans and
securities, and interest expense on interest-bearing deposits, FHLB advances,
and other borrowings. The Company's non-interest income is mainly derived from
service fees and other charges, mortgage banking income, and insurance
commissions. First Defiance's earnings also depend on the provision for loan
losses and non-interest expenses, such as employee compensation and benefits,
occupancy and equipment expense, deposit insurance premiums, and miscellaneous
other expenses, as well as federal income tax expense.
Common Stock Offering
During the first quarter of 2011, the Company completed an underwritten public
common stock offering by issuing 1,600,800 shares of the Company's common stock,
including 208,800 shares issued pursuant to the exercise of the underwriter's
over-allotment option, at a price of $13.25 per share for gross proceeds of
$21.2 million. The net proceeds to the Company after deducting underwriting
discounts and commissions and offering expenses were $19.9 million.
Participation in the U.S. Treasury Capital Purchase Program
On December 5, 2008, as part of the CPP, the Company entered into a Letter
Agreement and Securities Purchase Agreement (collectively, the "Purchase
Agreement") with the U.S. Treasury, pursuant to which the Company sold $37.0
million shares of newly authorized Fixed Rate Cumulative Perpetual Preferred
Stock, par value $0.01 per share and liquidation value $1,000 per share ("Senior
Preferred Shares") and also issued warrants (the "Warrants") to the U.S.
Treasury to acquire an additional 550,595 of common shares having an exercise
price of $10.08 per share. The Warrants have a term of 10 years.
The Senior Preferred Shares qualified as Tier 1 capital and paid cumulative
dividends at a rate of 5% per annum for the first five years, and 9% per annum
thereafter. The Senior Preferred Shares were not subject to any contractual
restrictions on transfer, except that the U.S. Treasury or any its transferees
could affect any transfer that, as a result of such transfer, would require the
Company to become subject to the periodic reporting requirements of Section 13
or 15(d) of the Securities Exchange Act of 1934.
Pursuant to the terms of the Purchase Agreement, the ability of the Company to
declare or pay dividends or distributions on, or purchase, redeem or otherwise
acquire for consideration, its common shares was subject to restrictions,
including a restriction against increasing dividends from the last quarterly
cash dividend per share of $0.26 declared on the common stock prior to October
14, 2008. The redemption, purchase or other acquisition of trust preferred
securities of the Company or its affiliates also was restricted. These
restrictions terminated on the third anniversary of the date of issuance of the
Senior Preferred Shares except that, after the third anniversary of the date of
issuance of the Senior Preferred Shares, the Company could not increase its
common dividends per share without obtaining consent of the U.S. Treasury.
51
The Purchase Agreement also subjected the Company to certain of the executive
compensation limitations included in the Emergency Economic Stabilization Act of
2008 (the "EESA"). As a condition to the closing of the transaction, the
Company's Senior Executive Officers (as defined in the Purchase Agreement) (the
"Senior Executive Officers"), (i) voluntarily waived any claim against the U.S.
Treasury or the Company for any changes to such officer's compensation or
benefits that are required to comply with the regulation issued by the U.S.
Treasury under the CPP and acknowledged that the regulation may require
modification of the compensation, bonus, incentive and other benefit plans,
arrangements and policies and agreements as they relate to the period the U.S.
Treasury owns the Senior Preferred Shares of the Company; and (ii) entered into
a letter agreement with the Company amending the Benefit Plans with respect to
such Senior Executive Officers as may be necessary, during the period that the
U.S. Treasury owns the Senior Preferred Shares, as necessary to comply with
Section 111(b) of the EESA.
In June 2012, the U.S. Treasury sold its preferred stock of the Company through
a public offering structured as a modified Dutch auction. The Company bid on its
preferred stock in the auction after receiving approval from its regulators. The
clearing price per share for the preferred shares was $962.66 (compared to a par
value of $1,000.00 per share) and the Company was successful in repurchasing
16,560 of the 37,000 preferred shares outstanding through the auction process.
Included in the second quarter of 2012 operating results is $181,000 of costs
incurred by the Company related to the offering. These costs are not
tax-deductible. The Company had also successfully acquired an additional 19,440
preferred shares in the secondary market prior to the end of the quarter. The
clearing prices per share for the preferred shares purchased in the secondary
market were as follows: 1,100 shares at $997.50, 1,500 shares at $1,000.00 and
16,840 shares at $998.75. The Company set up a payable for 16,840 of the 19,440
shares for $16,929,000 at the end of the quarter as these shares did not settle
until July 2, 2012. The net balance sheet impact was a reduction to
stockholders' equity of $35.4 million which is comprised of a decrease in
preferred stock of $36.0 million and a $642,000 increase to retained earnings
related to the discount on the shares repurchased.
On July 18, 2012, the Company purchased the remaining 1,000 preferred shares at
par value to complete the entire repurchase of the 37,000 preferred shares. All
of the shares will be retired.
Forward-Looking Information
Certain statements contained in this quarterly report are not historical facts,
including but not limited to statements that can be identified by the use of
forward-looking terminology such as "may", "will", "expect", "anticipate", or
"continue" or the negative thereof or other variations thereon or comparable
terminology are "forward-looking statements" within the meaning of Section 27A
of the Securities Act of 1933, as amended, and Section 21B of the Securities Act
of 1934, as amended. Actual results could differ materially from those indicated
in such statements due to risks, uncertainties and changes with respect to a
variety of market and other factors. The Company assumes no obligation to update
any forward-looking statements.
52
Changes in Financial Condition
At June 30, 2012, First Defiance's total assets, deposits and stockholders'
equity amounted to $2.07 billion, $1.61 billion and $249.9 million,
respectively, compared to $2.07 billion, $1.60 billion and $278.1 million,
respectively, at December 31, 2011.
Net loans receivable (excluding loans held for sale) increased $20.4 million to
$1.47 billion. The variances in loans receivable between June 30, 2012 and
December 31, 2011 include increases in commercial loans (up $23.2 million) and
one to four family residential real estate loans (up $6.9 million) mostly offset
by decreases in home equity and improvement loans (down $9.7 million), consumer
loans (down $0.6 million), commercial real estate loans (down $1.5 million) and
construction loans (down $8.6 million).
The investment securities portfolio increased $45.8 million to $279.4 million at
June 30, 2012 from $233.6 million at December 31, 2011. The increase is the
result of $82.8 million of securities being purchased during the first six
months of 2012, offset by $13.1 million of securities maturing or being called
in the period, principal pay downs of $18.7 million in CMOs and mortgage-backed
securities, and $6.0 million of securities being sold. There was an unrealized
gain in the investment portfolio of $8.3 million at June 30, 2012 compared to an
unrealized gain of $7.2 million at December 31, 2011.
Deposits increased from $1.60 billion at December 31, 2011 to $1.61 billion as
of June 30, 2012. Of the $17.4 million increase, interest-bearing demand
deposits and money market accounts increased $19.7 million to $628.8 million,
savings accounts increased $10.6 million to $165.7 million and
non-interest-bearing demand deposits increased $15.3 million to $261.2 million.
These increases were somewhat offset by a decline in retail time deposits of
$24.5 million to $551.0 million and broker/national certificates of deposit
decreasing by $3.7 million to $6.9 million.
Stockholders' equity decreased from $278.1 million at December 31, 2011 to
$249.9 million at June 30, 2012. The increases in stockholders' equity were the
result of recording net income of $8.1 million partially offset by $977,000 of
common stock dividends being paid and $897,000 of accrued dividends on preferred
stock. Also, $35.4 million was paid to redeem the outstanding preferred shares
as described above in the Participation in the U.S. Treasury Capital Purchase
Program section.
53
Average Balances, Net Interest Income and Yields Earned and Rates Paid
The following table presents for the periods indicated the total dollar amount
of interest from average interest-earning assets and the resultant yields, as
well as the interest expense on average interest-bearing liabilities, expressed
both in thousands of dollars and rates, and the net interest margin. The table
reports interest income from tax-exempt loans and investment on a tax-equivalent
basis. All average balances are based upon daily balances (dollars in
thousands).
Three Months Ended June 30,
2012 2011
Average Yield/ Average Yield/
Balance Interest(1) Rate(2) Balance Interest(1) Rate(2)
Interest-earning assets:
Loans receivable $ 1,462,312 $ 18,223 5.01 % $ 1,431,792 $ 19,874 5.57 %
Securities 273,017 2,384 3.62 195,790 2,099 4.36
Interest bearing deposits 147,730 114 0.31 210,050 140 0.27
FHLB stock 20,655 214 4.17 21,004 224 4.28
Total interest-earning
assets 1,903,714 20,935 4.44 1,858,636 22,337 4.83
Non-interest-earning
assets 198,961 206,464
Total assets $ 2,102,675 $ 2,065,100
Interest-bearing
liabilities:
Deposits $ 1,368,144 $ 2,116 0.62 % $ 1,363,700 $ 3,263 0.96 %
FHLB advances 81,823 750 3.69 96,934 768 3.18
Notes payable 52,921 97 0.74 56,796 140 0.99
Subordinated debentures 36,198 310 3.44 36,230 286 3.17
Total interest-bearing
liabilities 1,539,086 3,273 0.86 1,553,660 4,457 1.15
Non-interest bearing
deposits 260,950 - 228,086 -
Total including
non-interest bearing
demand deposits 1,800,036 3,273 0.73 1,781,746 4,457 1.00
Other
non-interest-bearing
liabilities 21,608
16,810
Total liabilities 1,821,644
1,798,556
Stockholders' equity 281,031
266,544
Total liabilities and
stockholders' equity $ 2,102,675 $ 2,065,100
Net interest income;
interest rate spread $ 17,662 3.58 % $ 17,880 3.68 %
Net interest margin (3) 3.75 % 3.86 %
Average interest-earning
assets to average
interest-bearing
liabilities 124 % 120 %
(1) Interest on certain tax-exempt loans and securities is not taxable for
Federal income tax purposes. In order to compare the tax-exempt yields on
these assets to taxable yields, the interest earned on these assets is
adjusted to a pre-tax equivalent amount based on the marginal corporate
federal income tax rate of 35%.
(2) Annualized
(3) Net interest margin is net interest income divided by average
interest-earning assets.
54
Six Months Ended June 30,
2012 2011
Average Yield/ Average Yield/
Balance Interest(1) Rate(2) Balance Interest(1) Rate(2)
Interest-earning assets:
Loans receivable $ 1,459,559 $ 36,902 5.08 % $ 1,444,764 $ 40,131 5.62 %
Securities 255,279 4,529 3.68 183,439 4,007 4.46
Interest bearing deposits 156,697 206 0.26 194,564 241 0.25
FHLB stock 20,655 443 4.31 21,008 459 4.42
Total interest-earning
assets 1,892,190 42,080 4.47 1,843,775 44,838 4.92
Non-interest-earning
assets 199,399 210,969
Total assets $ 2,091,589 $ 2,054,744
Interest-bearing
liabilities:
Deposits $ 1,366,583 $ 4,485 0.66 % $ 1,366,853 $ 6,857 1.01 %
FHLB advances 81,828 1,501 3.69 102,342 1,674 3.31
Notes payable 53,162 201 0.76 55,438 270 0.98
Subordinated debentures 36,198 641 3.56 36,230 612 3.42
Total interest-bearing
liabilities 1,537,771 6,828 0.89 1,560,863 9,413 1.22
Non-interest bearing
deposits 253,102 - 224,348 -
Total including
non-interest bearing
demand deposits 1,790,873 6,828 0.77 1,785,211 9,413 1.07
Other
non-interest-bearing
liabilities 20,276
15,498
Total liabilities 1,811,149
1,800,709
Stockholders' equity 280,440
254,035
Total liabilities and
stock- holders' equity $ 2,091,589 $ 2,054,744
Net interest income;
interest rate spread $ 35,252 3.58 % $ 35,425 3.70 %
Net interest margin (3) 3.76 % 3.89 %
Average interest-earning
assets to average
interest-bearing
liabilities 123 % 118 %
(1) Interest on certain tax-exempt loans and securities is not taxable for
Federal income tax purposes. In order to compare the tax-exempt yields on
these assets to taxable yields, the interest earned on these assets is
adjusted to a pre-tax equivalent amount based on the marginal corporate
federal income tax rate of 35%.
(2) Annualized
(3) Net interest margin is net interest income divided by average
interest-earning assets.
55
Results of Operations
Three Months Ended June 30, 2012 and 2011
On a consolidated basis, First Defiance's net income for the quarter ended June
30, 2012 was $3.9 million compared to net income of $4.8 million for the
comparable period in 2011. Net income applicable to common shares was $3.2
million for the second quarter of 2012 compared to $4.2 million for the
comparable period in 2011. On a per share basis, basic and diluted earnings per
common share for the three months ended June 30, 2012 were $0.33 and $0.32,
respectively, compared to basic and diluted earnings per common share of $0.44
and $0.43, respectively, for the quarter ended June 30, 2011.
Net Interest Income.
First Defiance's net interest income is determined by its interest rate spread
(i.e. the difference between the yields on its interest-earning assets and the
rates paid on its interest-bearing liabilities) and the relative amounts of
interest-earning assets and interest-bearing liabilities.
As demand for new lending opportunities remained soft in 2011 and into 2012, the
Company accelerated its strategy to increase investment security purchases by
selectively deploying lower yielding overnight deposits into investment
securities on the short to intermediate end of the yield curve. This will
continue throughout 2012 as management deems it appropriate within its liquidity
strategy and until management sees evidence of sustainable net loan growth.
Net interest income was $17.2 million for the quarter ended June 30, 2012, a
decrease from $17.5 million for the same period in 2011. The tax-equivalent net
interest margin was 3.75% for the quarter ended June 30, 2012 compared to 3.86%
for the same period in 2011. The decrease in margin between the 2011 and 2012
second quarters is mainly due to a declining of the interest rate spread, which
decreased to 3.58% in the second quarter of 2012 from 3.68% for the same period
in 2011. The decrease in spread occurred due to interest-earning asset yields
decreasing by 39 basis points (to 4.44% in the second quarter of 2012 from 4.83%
for the same period in 2011) which was partially offset by the cost of
interest-bearing liabilities between the two periods decreasing 29 basis points
(to 0.86% in the second quarter of 2012 from 1.15% in the same period in 2011).
Also, operating at a high level of liquidity along with lower loan yields has
impacted the net interest margin negatively in the second quarter of 2012.
Total interest income decreased by $1.5 million or 6.6% to $20.5 million for the
quarter ended June 30, 2012 from $22.0 million for the same period in 2011. The
decrease in interest income was due to a decline in asset yields, mainly as a
result of a drop in yields on loans receivable which declined 56 basis points to
5.01% at June 30, 2012. Interest income from loans decreased to $18.2 million
for the quarter ended June 30, 2012 compared to $19.8 million for the same
period in 2011, which represents a decline of 8.3%.
56
Interest expense decreased by $1.2 million in the second quarter of 2012
compared to the same period in 2011, to $3.3 million from $4.5 million. This
decrease was due to a 29 basis point decline in the average cost of
interest-bearing liabilities in the second quarter of 2012. Interest expense
related to interest-bearing deposits was $2.1 million in the second quarter of
2012 compared to $3.3 million for the same period in 2011. Interest expense
recognized by the Company related to subordinated debentures was $310,000 in the
second quarter of 2012 compared to $286,000 for the same period in 2011.
Expenses on FHLB advances and securities sold under repurchase agreements were
$750,000 and $97,000 respectively in the second quarter of 2012 compared to
$768,000 and $140,000 respectively for the same period in 2011.
Provision for Loan Losses.
The allowance for loan losses represents management's assessment of the
estimated probable credit losses in the loan portfolio at each balance sheet
date. Management analyzes the adequacy of the allowance for loan losses
regularly through reviews of the loan portfolio. Consideration is given to
economic conditions, changes in interest rates and the effect of such changes on
collateral values and borrower's ability to pay, changes in the composition of
the loan portfolio and trends in past due and non-performing loan balances. The
allowance for loan losses is a material estimate that is susceptible to
significant fluctuation and is established through a provision for loan losses
based on management's evaluation of the inherent risk in the loan portfolio. In
addition to extensive in-house loan monitoring procedures, the Company utilizes
an outside party to conduct an independent loan review of all commercial loan
and commercial real estate loan relationships that exceed $750,000 of aggregate
exposure over a twelve month period. Management utilizes the results of this
outside loan review to assess the effectiveness of its internal loan grading
system as well as to assist in the assessment of the overall adequacy of the
allowance for loan losses associated with these types of loans.
The provision for loan losses is determined by management as the amount to be
added to the allowance for loan losses after net charge-offs have been deducted
to bring the allowance to a level which, in management's best estimate, is
necessary to absorb probable credit losses within the existing loan portfolio in
the normal course of business. The allowance for loan loss is made up of two
basic components. The first component is the specific allowance in which the
Company sets aside reserves based on the analysis of individual credits. The
second component is the general reserve. The general reserve is used to record
loan loss reserves for groups of homogenous loans in which the Company estimates
the losses incurred in the portfolios based on quantitative and qualitative
factors. Due to the uncertainty of risks in the loan portfolio, the Company's
judgment on the amount of the allowance necessary to absorb loans losses is
approximate
In establishing specific reserves, First Federal analyzes all loans on its
classified and special mention lists at least quarterly and makes judgments
about the risk of loss based on the cash flow of the borrower, the value of any
collateral and the financial strength of any guarantor in determining the amount
of impairment of individual loans and the specific reserve to be recorded.
For purposes of the general reserve analysis, the loan portfolio is stratified
into nine different loan pools based on loan type and by market area to allocate
historic loss experience. The loss experience factor applied to the non-impaired
loan portfolio was based upon historical losses of the most recent rolling eight
quarters ending June 30, 2012.
57
The stratification of the loan portfolio resulted in a quantitative general
allowance of $18.2 million at June 30, 2012 compared to $19.5 million at
December 31, 2011.
In addition to the quantitative analysis, a qualitative analysis is performed
each quarter to provide additional general reserves on the non-impaired loan
portfolio for various factors that have a bearing on its loss content, including
but not limited to the following:
· Changes in international, national and local economic and business
conditions and developments, including the condition of various market
segments
· Changes in the nature and volume of the loan portfolio
· Changes in the trends of the volume and severity of past due and
classified loans; and changes in trends in the volume of non-accrual
loans, troubled debt restructurings and other loan modifications
· The existence and effect of any concentrations of credit and changes in
the level of such concentrations
· Changes in the value of underlying collateral for collateral dependent loans
· Changes in the political and regulatory environment
· Changes in lending policies and procedures, including underwriting
standards and collection, charge-off and recovery practices
· Changes in the experience, ability and depth of lending management and staff
· Changes in the quality and breadth of the loan review process
The qualitative analysis at June 30, 2012 indicated a general reserve of $7.4
million compared with $6.5 million at December 31, 2011. Thirteen of the
fourteen counties in the Company's footprint were below the national
unemployment average of 7.9% as of June 30, 2012. The unemployment rates in May
2012 range from a low of 5.4% to a high of 8.6% compared to the unemployment
rates in December 2011 ranging from a low of 7.4% to a high of 13.3%. May was
the last month available for unemployment rates when preparing this report.
As a result of the quantitative and qualitative analyses, along with the change
in specific reserves, the Company's provision for loan losses for the second
quarter of 2012 was $4.1 million, compared to $2.4 million for the same period
in 2011. The allowance for loan losses was $26.4 million and $33.3 million and
represented 1.76% and 2.24% of loans, net of undisbursed loan funds and deferred
fees and costs, as of June 30, 2012 and December 31, 2011, respectively. The
provision of $4.1 million was offset by charge offs of $4.1 million against
specific reserves and $2.7 million against general reserves and recoveries of
$265,000 resulting in a decrease to the overall allowance for loan loss at June
30, 2012. The decline in the allowance for loan loss is supported by the overall
improvement in asset quality evidenced by the decline in loan delinquencies and
classified loans. Total charge-offs were elevated in the second quarter of 2012.
These charge-offs were not due to any new credits, but from previously
identified credits for which $2.7 million of specific reserves were previously
established and further updated collateral valuation information was received
during the period resulting in the classification of the loans as collateral
dependent and the additional charge-offs. In management's opinion, the overall
allowance for loan losses of $26.4 million as of June 30, 2012 is adequate.
58
Management also assesses the value of real estate owned as of the end of each
accounting period and recognizes write-downs to the value of that real estate in
the income statement if conditions dictate. In the second quarter of 2012, First
Defiance recorded OREO write-downs that totaled $126,000 compared to write-downs
of $259,000 for the same period in 2011. These write-downs are primarily due to
decreasing the liquidation values in order to spur interest in our market areas
to sell these properties. These amounts are included in other non-interest
expense. Management believes that the values recorded at June 30, 2012 for real
estate owned and repossessed assets represent the realizable value of such
assets.
Total classified loans decreased to $95.1 million at June 30, 2012, compared to
$122.5 million at December 31, 2011. First Federal also has classified $0 of
loans doubtful at June 30, 2012, compared to $10,000 at December 31, 2011.
First Federal's ratio of allowance for loan losses to non-performing loans was
58.3% at June 30, 2012 compared with 77.9% at December 31, 2011. Management
monitors collateral values of all loans included on the watch list that are
collateral dependent and believes that allowances for those loans at June 30,
2012 are appropriate. The Company did experience a decrease in non-accrual loans
in the second quarter of 2012. Of the total non-accrual loans, $23.9 million or
57.4%, are 90 days or less past due and paying in accordance with the terms
of
the note.
At June 30, 2012, First Defiance had total non-performing assets of $48.8
million, compared to $46.3 million at December 31, 2011. Non-performing assets
include loans that are 90 days past due, troubled debt restructured loans and
real estate owned and other assets held for sale. Non-performing assets at June
30, 2012 and December 31, 2011 by category were as follows:
59
Table 1 - Non-Performing Asset
June 30, December 31,
2012 2011
(In thousands)
Non-performing loans:
Single-family residential $ 5,352 $ 3,890
Construction - -Non-residential and multi-family residential real estate 29,000
28,150
Commercial 6,900 6,884
Consumer finance 4 10
Home equity and improvement 446 394
Troubled debt restructured loans, accruing 3,581
3,380
Total non-performing loans 45,283
42,708
Real estate owned and repossessed assets 3,538
3,628
Total non-performing assets $ 48,821
$ 46,336
Allowance for loan losses as a percentage of total loans* 1.76 % 2.24 %
Allowance for loan losses as a percentage of
non-performing assets 54.09 % 71.77 %
Allowance for loan losses as a percentage of
non-performing loans 58.32 %
77.86 %
Total non-performing assets as a percentage of total
assets
2.36 % 2.24 %
Total non-performing loans as a percentage of total loans* 3.02 %
2.87 %
* Total loans are net of undisbursed loan funds and deferred fees and costs.
The largest category in non-performing loans is commercial real estate loans.
The balance of this type of non-performing loan was $850,000 higher at June 30,
2012 compared to December 31, 2011.
Non-performing loans in the commercial real estate category represented 3.74% of
the total loans in those categories at June 30, 2012 compared to 3.63% for the
same category at December 31, 2011. Management believes that the current
allowance for loan losses is appropriate and that the provision for loan losses
recorded in the second quarter of 2012 is consistent with both charge-off
experience and the risk inherent in the overall credits in the portfolio.
First Federal's Asset Review Committee meets monthly to review the status of
work-out strategies for all criticized relationships, which include all
non-accrual loans. Based on such factors as anticipated collateral values in
liquidation scenarios, cash flow projections, assessment of net worth of
guarantors and all other factors which may mitigate risk of loss, the Asset
Review Committee makes recommendations regarding required allowances and
proposed charge-offs which are approved by the Senior Loan Committee (in the
case of charge-offs) or the Loan Loss Reserve Committee (in the case of specific
allowances).
The following table details net charge-offs and nonaccrual loans by loan type.
For the six months ended and as of June 30, 2012, commercial real estate, which
represented 51.33% of total loans, accounted for 67.85% of net charge-offs and
69.54% of nonaccrual loans, and commercial loans, which represented 24.64% of
total loans, accounted for 20.75% of net charge-offs and 16.55% of nonaccrual
loans. For the six months ended and as of June 30, 2011, commercial real estate,
which represented 50.46% of total loans, accounted for 52.97% of net charge-offs
and 56.20% of nonaccrual loans, and commercial loans, which represented 23.10%
of total loans, accounted for 3.11% of net charge-offs and 29.85% of nonaccrual
loans.
60
Table 2 - Net Charge-offs and Non-accruals by Loan Type
For the Six Months Ended June 30, 2012 As of June 30, 2012
Net % of Total Net Nonaccrual % of Total Non-
Charge-offs Charge-offs Loans Accrual Loans
(in thousands) (in thousands)
Residential $ 1,198 8.29 % $ 5,352 12.83 %
Construction - 0.00 % - 0.00 %
Commercial real estate 9,801 67.85 % 29,000 69.54 %
Commercial 2,997 20.75 % 6,900 16.55 %
Consumer 23 0.16 % 4 0.01 %Home equity and improvement 426
2.95 % 446 1.07 %
Total $ 14,445 100.00 % $ 41,702 100.00 %
For the Six Months Ended June 30, 2011 As of June 30, 2011
Net %of Total Net Nonaccrual % of Total Non-
Charge-offs Charge-offs Loans Accrual Loans
(in thousands) (in thousands)
Residential $ 880 32.92 % $ 4,368 12.65 %
Construction - 0.00 % 60 0.17 %Commercial real estate 1,416
52.97 % 19,404 56.20 %
Commercial 83 3.11 % 10,307 29.85 %
Consumer 5 0.19 % 18 0.05 %
Home equity and improvement 289
10.81 % 371 1.08 %
Total $ 2,673 100.00 % $ 34,528 100.00 %
Table 3 - Allowance for Loan Loss Activity
For the Quarter Ended
2nd 2012 1st 2012 4th 2011 3rd 2011 2nd 2011
(Dollars in Thousands)
Allowance at beginning of period $ 28,833 $ 33,254 $ 38,110 $ 40,530 $ 40,798
Provision for credit losses 4,097 3,503 4,099 3,097 2,405
Charge-offs:
Residential 584 738 666 647 893
Commercial real estate 5,448 4,496 6,737 2,622 1,517
Commercial 486 2,666 1,423 2,533 107
Consumer finance 14 41 28 36 20
Home equity and improvement 254 211 251 290 310
Total charge-offs 6,786 8,152 9,105 6,128 2,847
Recoveries 265 228 150 611 174
Net charge-offs 6,521 7,924 8,955 5,517 2,673
Ending allowance $ 26,409 $ 28,833 $ 33,254 $ 38,110 $ 40,530
61
The following table sets forth information concerning the allocation of First
Federal's allowance for loan losses by loan categories at the dates indicated.
Table 4 - Allowance for Loan Loss Allocation by Loan Category
June 30, 2012 March 31, 2012 December 31, 2011 September 30, 2011 June 30, 2011
Percent of Percent of Percent of Percent of Percent of
total loans total loans total loans total loans total loans
Amount by category Amount by category Amount by category Amount by category Amount by categoryResidential $ 3,104 13.94 % $ 3,373 13.58 % $ 4,095 13.55 % $ 4.023 12.86 % $ 5.930 14.62 %
Construction 48 1.52 % 73 2.44 % 4 63 2.10 % 69 2.39 % 47 1.64 %
Commercial
real estate 16,562 51.33 % 19,031 53.10 % 20,490 51.70 % 24,523 51.96 % 24,397 50.46 %
Commercial 5,087 24.64 % 4,693 21.97 % 6 6,576 23.25 % 7,804 22.99 % 8,290 23.10 %
Consumer 140 1.13 % 178 1.19 % 174 1.26 % 219 1.34 % 227 1.40 %
Home equity
and
improvement 1,468 7.44 % 1,485 7.72 % 1,856 8.14 % 1,472 8.47 % 1,639 8.78 %
$ 26,409 100.00 % $ 28,833 100.00 % $ 33,254 100.00 % $ 38,110 100.00 % $ 40,530 100.00 %
Key Asset Quality Ratio Trends
Table 5 - Key Asset Quality Ratio Trends
2nd Qtr 2012 1st Qtr 2012 4th Qtr 2011 3rd Qtr 2011 2nd Qtr 2011
Allowance for loan losses /
loans*
1.76 % 1.96 % 2.24 % 2.61 % 2.80 %
Allowance for loan losses to
net charge-offs 404.98 % 363.87 % 371.35 % 690.77 % 1,526.27 %
Allowance for loan losses /
non-performing assets 54.09 % 54.84 % 71.77 % 66.82 % 84.16 %
Allowance for loan losses /
non-performing loans 58.32 % 58.64 % 77.86 % 74.39 % 99.41 %
Non-performing assets / loans
plus REO* 3.25 % 3.56 % 3.11 % 3.89 % 3.31 %
Non-performing assets / total
assets 2.36 % 2.45 % 2.24 % 2.77 % 2.35 %
Net charge-offs / average loans
(annualized) 1.78 % 2.18 % 2.49 % 1.55 % 0.75 %
* Total loans are net of undisbursed funds and deferred fees and costs.
Non-Interest Income.
Total non-interest income increased $1.2 million in the second quarter of 2012
to $8.0 million from $6.8 million for the same period in 2011.
Service Fees. Service fees and other charges decreased by $60,000 or 2.2% in the
2012 second quarter compared to the same period in 2011.
First Federal's overdraft privilege program generally provides for the automatic
payment of modest overdraft limits on all accounts deemed to be in good standing
when the account is accessed using paper-based check processing, a teller
withdrawal, a point-of-sale terminal, an ACH transaction, an online banking or
voice-response transfer, or an ATM. To be in good standing, an account must be
brought to a positive balance within a 30-day period and have not excessively
used the overdraft privilege program. Overdraft limits are established for all
customers without discrimination using a risk assessment approach for each
account classification. The approach includes a systematic review and evaluation
of the normal deposit flows made to each account classification to establish
reasonable and prudent negative balance limits that would be routinely repaid by
normal, expected and reoccurring deposits. The risk assessment by portfolio
approach assumes a minimal degree of undetermined credit risk associated with
unidentified individual accounts that are overdrawn for 30 or more days.
Consumer accounts overdrawn for more than 60 days are automatically charged off.
Fees are charged as a one-time fee per occurrence, up to five charges per day,
and the fee charged for an item that is paid is equal to the fee charged for a
non-sufficient fund item that is returned.
62
Overdrawn balances, net of allowance for losses, are reflected as loans on First
Defiance's balance sheet. The fees charged for this service are established
based both on the return of processing costs plus a profit, and on the level of
fees charged by competitors in the Company's market area for similar services.
These fees are considered to be compensation for providing a service to the
customer and therefore deemed to be noninterest income rather than interest
income. Fee income recorded for the quarters ending June 30, 2012 and 2011
related to the overdraft privilege product, net of adjustments to the allowance
for uncollectible overdrafts, were $1.1 million and $1.5 million, respectively.
Accounts charged off are included in noninterest expense. The allowance for
uncollectible overdrafts was $16,000 at June 30, 2012, $67,000 at December 31,
2011 and $123,000 at June 30, 2011.
Mortgage Banking Activity.Total revenue from the sale and servicing of mortgage
loans increased $352,000 to $2.3 million for the second quarter of 2012 compared
to $1.9 million for the same period of 2011. This increase was primarily due to
higher loan origination volume for the quarter, the result of higher refinancing
activity due to lower interest rates on conforming saleable mortgage-based
products in the second quarter of 2012 compared to the same period in 2011.
Gains realized from the sale of mortgage loans increased in the second quarter
of 2012 to $2.5 million from $1.1 million in the same period of 2011. The
amortization of mortgage servicing rights expense increased $513,000 to $855,000
in the second quarter of 2012 compared to $342,000 in the same period in 2011.
The Company recorded a negative valuation adjustment of $177,000 on mortgage
servicing rights in the second quarter of 2012 compared to a positive valuation
adjustment of $316,000 for the same period of 2011. The negative valuation
adjustment in the second quarter of 2012 was driven by a decline in the fair
values of certain sectors of the Company's portfolio of mortgage servicing
rights.
Insurance and Investment Sales Commissions. Income from the sale of insurance
and investment products increased $743,000 in the second quarter of 2012 to $2.2
million from $1.4 million for the same period of 2011. In July 2011, First
Insurance acquired a full insurance agency. This acquired agency added
approximately $693,000 in revenue in the second quarter of 2012.
Impairment of Securities. First Defiance did not have any other-than-temporary
impairment ("OTTI") charges in the second quarter of 2012 and for the same
period in 2011 reflecting a more stable environment relating to its Trust
Preferred Collateralized Debt Obligation ("CDO") investments. In June 2012, the
Company was notified that its Preferred Term Security VI was redeemed through an
auction process. The security was redeemed at full price with proceeds being
received in July 2012. This security had previously identified OTTI of $80,000.
The previous OTTI amount was recorded as a yield adjustment in interest income
as of June 30, 2012.
Other non-interest income.Other non-interest income decreased $76,000 in the
second quarter of 2012 from $130,000 for the same period in 2011. This decrease
in mainly attributable to the decrease in the value of the assets of the
deferred compensation plan of $91,000 in the second quarter of 2012 compared to
$13,000 for the same period in 2011.
63
Non-Interest Expense.
Non-interest expense increased to $15.5 million for the second quarter of 2012
compared to $15.1 million for the same period in 2011.
Compensation and Benefits. Compensation and benefits increased to $8.0 million
for the quarter ended June 30, 2012 from $7.5 million for the same period in
2011. The increase is mainly attributable to the July 2011 insurance acquisition
that added approximately $389,000 in compensation and benefits expense in the
second quarter of 2012.
Other Non-Interest Expenses. Other non-interest expenses decreased by $169,000
to $3.0 million for the quarter ended June 30, 2012 from $3.2 million for the
same period in 2011. The main driver behind the decrease between the 2012 and
2011 second quarters is a reduction in credit related costs. Credit, collection
and real estate owned costs were $524,000 in the second quarter of 2012 compared
to $894,000 for the same period in 2011. This was slightly offset by an increase
in secondary market buy-back losses of $11,000 in the second quarter of 2011.
The efficiency ratio, considering tax equivalent interest income and excluding
securities gains and losses, for the second quarter of 2012 was 61.45% compared
to 61.03% for the same period in 2011.
Income Taxes.
First Defiance computes federal income tax expense in accordance with ASC Topic
740, Subtopic 942, which resulted in an effective tax rate of 30.1% for the
quarter ended June 30, 2012 compared to 30.8% for the same period in 2011. The
tax rate is lower than the statutory 35% tax rate for the Company mainly because
of investments in tax-exempt securities. The earnings on tax-exempt securities
are not subject to federal income tax.
Six Months Ended June 30, 2012 and 2011
On a consolidated basis, First Defiance's net income for the six months ended
June 30, 2012 of $8.1 million compared to income of $7.4 million for the
comparable period in 2011. Net income applicable to common shares was $6.8
million for the six months ended June 30, 2012 compared to $6.4 million for the
comparable period in 2011. On a per share basis, basic and diluted earnings per
common share for the six months ended June 30, 2011 were $0.70 and $0.68,
respectively, compared to basic and diluted earnings per common share of $0.71
and $0.70, respectively, for the comparable period in 2011.
Net Interest Income.
Net interest income was $34.4 million for the six months ended June 30, 2012
compared to $34.7 million for the same period in 2011. For the six month period
ended June 30, 2012, total interest income was $41.3 million, a $2.9 million
decrease from the same period in 2011. Despite average earning assets increasing
$48.4 million in the first six months of 2012, the average yield declined 45
basis points as a result of a lower rate environment.
64
Interest expense decreased by $2.6 million to $6.8 million for the six months
ended June 30, 2012 compared to $9.4 million for the same period in 2011. The
decline in the average cost of interest-bearing liabilities for the six months
ending June 30, 2012, to 0.89%, a 33 basis point decrease from the 1.22% average
cost in the first half of 2011 is the result of the continued low rate
environment which has given management opportunities to re-price on the
liability side.
Provision for Loan Losses.
The provision for loan losses was $7.6 million for the six months ended June 30,
2012, compared to $5.2 million during the six months ended June 30, 2011. The
year over year increase was primarily the result of conforming to regulatory
guidance in the treatment of loans deemed to now be collateral dependent. Lower
appraisals continue to result in additional charges against loans previously
identified but no longer show verifiable cash flow. Some of these loans continue
to remain current but are now considered collateral dependent requiring a
write-down for their collateral short-fall. Charge-offs for the first half of
2012 were $14.9 million and recoveries of previously charged off loans totaled
$493,000 for net charge-offs of $14.4 million. By comparison, $6.2 million of
charge-offs were recorded in the same period of 2011 and $427,000 of recoveries
were realized for net charge-offs of $5.8 million.
Non-Interest Income.
Total non-interest income increased to $16.4 million for the six months ended
June 30, 2012 from $12.8 million recognized in the same period of 2011.
Mortgage Banking Activity.Total revenue from the sale and servicing of mortgage
loans increased 47.3% to $4.7 million for the six months ended June 30, 2012
from $3.2 million for the same period of 2011. Gains realized from the sale of
mortgage loans increased $3.2 million to $5.0 million for the first half of 2012
from $1.8 million during the same period of 2011. Mortgage loan servicing
revenue remained flat at $1.7 million in the first half of 2012 compared to the
same period of 2011. The increase in gains were partially offset by an expense
increase of $922,000 for the amortization of mortgage servicing rights in the
first half of 2012 when compared to 2011. The Company recorded a negative
valuation adjustment of $255,000 in the first half of 2012 compared to a
positive adjustment of $487,000 in the first half of 2011.
Insurance and Investment Sales Commission. Insurance and investment sales
commission income increased $1.6 million, to $4.7 million for the six months
ended June 30, 2012, from $3.1 million during the same period of 2011. This is
the result of receiving more contingent commission income in the first half of
2012 compared to the first half of 2011. In 2012, $508,000 was received compared
to $329,000 in 2011. The insurance agency acquired from PDI added approximately
$1.3 million in revenue in the first six months of 2012.
Loss on Securities. First Defiance did not have any OTTI charges in the first
six months of 2012 reflecting a more stable environment relating to its CDO
investments. In the first six months of 2011, First Defiance recognized OTTI
charges of $2,200 for one impaired investment security, where in management's
opinion, the value of the investment will not be fully recovered. The OTTI
charge related to one CDO investment with a remaining book value of $902,000.
65
Non-Interest Expense.
Non-interest expense increased to $31.8 million for the first six months of 2012
compared to $31.7 million for the same period in 2011.
Compensation and Benefits. Compensation and benefits increased to $16.5 million
for the six months ended June 30, 2012 from $15.3 million for the same period in
2011. The increase is mainly attributable to the July 2011 insurance acquisition
that added approximately $796,000 in compensation and benefits expense in the
first six months of 2012. Also, the Company experienced an increase in
commission expense as a result of the increased insurance activity.
FDIC Insurance Premiums. FDIC expense decreased to $1.3 million in the first six
months of 2012, from $1.6 million in the same period of 2011. This decrease was
the result of the change in the rate assessment calculation in September 2011
affected by the Dodd-Frank legislation.
Other Non-Interest Expenses. Other non-interest expenses (including state
franchise tax, data processing, amortization of intangibles and other) decreased
by $670,000 to $10.4 million for the first six months of 2012 from $11.1 million
for the same period in 2011. Year-over-year decreases between 2012 and 2011
include a reduction in secondary market buy-back losses of $218,000 as a result
of underwriting issues identified in the first six months of 2011 after the
loans had been sold and a $649,000 reduction in other credit related costs which
includes credit, collection and other real estate owned expenses.
The efficiency ratio for the first half of 2012 was 62.04% compared to 65.85%
for the same period of 2011.
Liquidity
As a regulated financial institution, First Federal is required to maintain
appropriate levels of "liquid" assets to meet short-term funding requirements.
First Defiance had $22.8 million of cash provided by operating activities during
the first six months of 2012. The Company's cash used in operating activities
resulted from the origination of loans held for sale mostly offset by the
proceeds on the sale of loans.
At June 30, 2012, First Federal had $94.7 million in outstanding loan
commitments and loans in process to be funded generally within the next six
months and an additional $270.2 million committed under existing consumer and
commercial lines of credit and standby letters of credit. Also at that date,
First Federal had commitments to sell $60.7 million of loans held-for-sale.
First Defiance believes that it has adequate resources to fund commitments as
they arise and that it can adjust the rate on savings certificates to retain
deposits in changing interest rate environments. If First Defiance requires
funds beyond its internal funding capabilities, advances from the FHLB of
Cincinnati and other financial institutions are available.
66
Liquidity risk arises from the possibility that the Company may not be able to
meet its financial obligations and operating cash needs or may become overly
reliant upon external funding sources. In order to manage this risk, the
Company's Board of Directors has established a Liquidity Policy that identifies
primary sources of liquidity, establishes procedures for monitoring and
measuring liquidity and quantifies minimum liquidity requirements. This policy
designates First Federal's Asset/Liability Committee ("ALCO") as the body
responsible for meeting these objectives. The ALCO reviews liquidity on a
monthly basis and approves significant changes in strategies that affect balance
sheet or cash flow positions. Liquidity is centrally managed on a daily basis by
the Company's Chief Financial Officer and Controller.
The ALCO uses an economic value of equity ("EVE") analysis to measure risk in
the balance sheet incorporating all cash flows over the estimated remaining life
of all balance sheet positions. The EVE analysis calculates the net present
value of First Federal's assets and liabilities in rate shock environments that
range from -400 basis points to +400 basis points. The likelihood of a decrease
in rates as of June 30, 2012 was considered to be remote given the current
interest rate environment and therefore, was not included in this analysis. The
results of this analysis are reflected in the following tables for the six
months ended June 30, 2012 and the year-ended December 31, 2011.
June 30, 2012
Economic Value of Equity
Change in Rates $ Amount $ Change % Change
(Dollars in Thousands)
+400 bp 435,611 61,637 16.48 %
+ 300 bp 425,753 51,779 13.85 %
+ 200 bp 412,872 38,898 10.40 %
+ 100 bp 396,920 22,946 6.14 %
0 bp 373,974 - -
December 31, 2011
Economic Value of Equity
Change in Rates $ Amount $ Change % Change
(Dollars in Thousands)
+400 bp 471,564 64,772 15.92 %
+ 300 bp 460,756 53,964 13.27 %
+ 200 bp 447,035 40,243 9.89 %
+ 100 bp 430,361 23,570 5.79 %
0 bp 406,792 - -
Capital Resources
Capital is managed at First Federal and on a consolidated basis. Capital levels
are maintained based on regulatory capital requirements and the economic capital
required to support credit, market, liquidity and operational risks inherent in
our business, as well as flexibility needed for future growth and new business
opportunities.
Capital Purchase Plan Capital
During 2008, First Defiance received $37 million of equity capital by issuing
37,000 shares of Preferred Stock to the U.S. Department of Treasury, and a
ten-year warrant to purchase up to 550,595 shares of First Defiance's common
stock, par value $0.01 per share, at an exercise price of $10.08 per share. The
proceeds received were allocated to the preferred stock and additional
paid-in-capital.
67
In June 2012, the U.S. Treasury sold its preferred stock of the Company through
a public offering structured as a modified Dutch auction. The Company bid on its
preferred stock in the auction after receiving approval from its regulators. The
clearing price per share for the preferred shares was $962.66 (compared to a par
value of $1,000.00 per share) and the Company was successful in repurchasing
16,560 of the 37,000 preferred shares outstanding through the auction process.
Included in the second quarter of 2012 operating results is $181,000 of costs
incurred by the Company related to the offering. These costs are not
tax-deductible. The Company had also successfully acquired an additional 19,440
preferred shares in the secondary market prior to the end of the second quarter.
The net balance sheet impact was a reduction to stockholders' equity of $35.4
million which is comprised of a decrease in preferred stock of $36.0 million and
a $642,000 increase to retained earnings related to the discount on the shares
repurchased. In July, the Company acquired the remaining 1,000 preferred shares
to complete the entire repurchase of the 37,000 preferred shares.
Capital Adequacy
First Federal is required to maintain specified amounts of capital pursuant to
regulations promulgated by the Office of the Comptroller of the Currency. The
capital standards generally require the maintenance of regulatory capital
sufficient to meet a tangible capital requirement, a core capital requirement,
and a risk-based capital requirement. The following table sets forth First
Federal's compliance with each of the capital requirements at June 30, 2012
(in
thousands).
Minimum Required for Minimum Required for Well
Actual Adequately Capitalized Capitalized
Amount Ratio Amount Ratio Amount RatioTier 1 Capital (1)
Consolidated $ 217,430 10.90 % $ 79,759 4.0 % $ 99,699 6.0 %
First Federal Bank $ 205,515 10.32 % $ 79,632 4.0 % $ 99,540 6.0 %
Total Capital (to
Risk Weighted
Assets) (1)
Consolidated $ 238,385 14.27 % $ 133,677 8.0 % $ 167,097 10.0 %
First Federal Bank $ 226,444 13.57 % $ 133,510 8.0 % $ 166,888 10.0 %
(1) Core capital is computed as a percentage of adjusted total assets of $1.99
billion and $1.99 billion for consolidated and the bank, respectively.
Risk-based capital is computed as a percentage of total risk-weighted assets
of $1.67 billion and $1.67 billion for consolidated and the bank,
respectively.
Critical Accounting Policies
First Defiance has established various accounting policies which govern the
application of accounting principles generally accepted in the United States in
the preparation of its financial statements. The significant accounting policies
of First Defiance are described in the footnotes to the consolidated financial
statements included in the Company's Annual Report on Form 10-K. Certain
accounting policies involve significant judgments and assumptions by management,
which have a material impact on the carrying value of certain assets and
liabilities; management considers such accounting policies to be critical
accounting policies. Those policies which are identified and discussed in detail
in the Company's Annual Report on Form 10-K include the Allowance for Loan
Losses, Valuation of Securities, and the Valuation of Mortgage Servicing Rights.
There have been no material changes in assumptions or judgments relative to
those critical policies during the first six months of 2012.
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